Efficiency Wage Theory: How Higher Wages Affect Worker Productivity

This essay analyzes the relationship between worker efficiency and higher wages. The efficiency wage theory explains why firms offer wages above the equilibrium wage. The essay also compares the salary structure of KFC and McDonald's in Australia. The findings suggest that higher wages can increase worker productivity and promote business expansion.

Running head: HR ECONOMICS
HR Economics
Name of the Student
Name of the University
Course ID

1HR ECONOMICS
Introduction
The essay aims to analyze how efficiency of workers are related to higher wages. Wage
refers to the return that workers receive in exchange of their work effort. It is the incentives for
workers to work. In a free market, combined forces of demand and supply determine equilibrium
wages. The equilibrium wage is considered efficient in determining full employment. However,
wages are often paid above the equilibrium wage. An important theory that explains the rationale
for offering wage beyond the equilibrium wage is the theory of efficiency wage (Weiss 2014).
The theory of efficiency wage considers work effort as an important component in determining
productivity of workers. Monitoring work efforts is costly. Therefore, incentives are provided to
the workers in form of in form of higher wages above the equilibrium. The hypothesis of adverse
selection suggests a correlation between reservation wage and productivity of workers. The
hypothesis proposes that a higher wage attracts a better quality worker. These workers also
receive internal incentives for performing well. In the model of shirking threat, external
incentives are given to workers to increase work effort. There are other theories as well that
support the efficiency wage theory such as turnover model, model for workers’ health and others.
Equilibrium wage is often determined at such a low level that create dissatisfaction among
workers. The dissatisfaction harms workers’ productivity and increases attrition in the
workplace. There are however, theories that contradict the proposition of efficiency wage
(Georgiadis 2013). The backward bending labor supply curve suggest that labor supply does not
increase uniformly with increase in wages. Beyond a certain level of wage labor supply falls, as
workers give priority to leisure time over work effort.
The body of this paper has been divided into three parts. In the first part, theoretical
literatures are discussed by considering the past studies. In the second part, empirical test has

2HR ECONOMICS
been conducted to compare salaries of sales representatives of KFC and Mc Donald. The third
part finally suggest how workers can be motivated with efficiency drawing reference from past
literature.
Literature review
Cyclical fluctuation and efficiency wage: The Keynesian economists suggests that business cycle
fluctuations are characterized by existence of involuntary unemployment. It is however difficult
to develop a business cycle model with involuntary unemployment because of difficulty in
explaining non-clearance of labor market. Involuntarily unemployed people agree to work at a
wage below the equilibrium (Ehrenberg and Smith 2016). Despite this, firms do not cut wage to
increase profitability. The efficiency wage theories explain why firms find it unprofitable to cut
wages during involuntary unemployment.
Studies found that the movement of work effort as described by efficiency wage is
countercyclical. Work effort should be go up when unemployment increases. In terms of
economic theory, firing a worker has a lower chance of getting another job during high
unemployment. This makes unemployment more threatening. Proponents supporting this
argument concluded that high unemployment is associated with a lower rate of turnover
indicating less rehiring. There are however studies that have found the opposite arguments to be
true. That is during high unemployment turnover tend to be higher as well. Work effort
explaining the foundation of efficiency wage in found to be inversely related with unemployment
created during business cycle fluctuation. There is a simple intuition behind this. The micro
foundation theory of labor market suggests that workers in the primary labor market only fears to
be monitored (Lavoie and Stockhammer 2013). When the chance of keeping a job in primary
labor market decreases because of high unemployment, less importance then is given to that fear.

3HR ECONOMICS
During this time, workers cannot be threatened for being monitored or fired as they already faced
high risk of losing jobs.
Backward bending labor supply curve: The theory of backward bending labor supply curve bears
great policy implication. The theory contradicts the traditional theory of upward sloping supply
curve. The notion of upward sloping supply curve based on the assumption that substitution
effect for a change in wage always dominates the income effect making the labor supply curve
upward sloping. In real world, however income effect might dominate substitution effect making
the labor supply curve to bend backward (Kool and Botvinick 2014). Many studies found in the
absence of income effect, labor supply curve slopes downward.
The labor supply curve explains the association between available supply of labor and
market wage. In general, the labor supply curve is assumed to be positively sloped. The positive
association between wage and labor supply however does not hold always. Evidences from real
world suggest that the labor supply curve is bending backward. This can be explained with
income and substitution effect. As income increase, workers can afford more goods and services.
This is the income effect of increased wage. Higher wage means a higher opportunity cost for
leisure. Workers thus tend to substitute leisure with work hours (Brecher and Gross 2014). This
is the substitution effect of increased wage. The ultimate impact on labor supply is subject to
magnitude of income and substitution effect.
Relation between efficiency wage and backward bending labor supply curve

4HR ECONOMICS
Figure 1: Income effect and substitution effect of wage change
(Source: Johnson 2017)
The vertical axis measures money income or wage. In the horizontal axis, both labor
supply and work hours are measured. With initial wage of W0, the money income line is given as
M0T. Equilibrium is attained at the point R. The work hours is equivalent to L0T and leisure
hours is given as OL0. As wage increases, the money income line shifted to TM1. Corresponding
to the new wage, the equilibrium point shifted to H. The new equilibrium is associated with a
higher leisure hours of OL1 and smaller work effort to L1T. The substitution effect attempts to
increase work effort from L0T to L2T. The income effect on the other hand attempts to lower the
work hours L2T to L1T. As income effect is larger than substitution effect, the ultimate effect is
lowering the work effort.
Need for paying efficiency wage for workers
There are different explanation for offering a high wage to the workers. In context of less
developed countries, the first explanation is in term of linkage between wage, nutrition and

5HR ECONOMICS
health of workers. For developed economies, arguments that are more appealing are given by
shirking model, turnover model and adverse selection model.
The Shirking Model: In most of the jobs, workers have some discretion regarding performance.
The employment contracts cannot rigidly cover all aspect of their job duty and responsibility.
Monitoring every worker is a costly practice and often gives inaccurate result (Card et al. 2018).
Under this circumstance, offering wage above the equilibrium wage might be an effective way to
reduce shirking. The higher wage provides workers incentive to work instead to shirking.
Turnover Model: High wage is often offered to reduce turnover rate in the firm. The argument of
turnover model is same as that of shirking model. With relatively high wageworkers are more
reluctant to leave the high paid job of the existing firm (Booth 2014). When all firms in the
industry are identical, paying workers wage above the equilibrium with involuntary
unemployment help to lower turnover rate.
Adverse Selection Model: The model of adverse selection provides another explanation for the
relation between wage and productivity of workers. A positive correlation between ability of
workers and reservation wage implies higher wage helps to attract more abled workers. In this
model, firms by offering an efficiency wage drives away applicants from firms offering a
comparatively lower wage. Workers’ willingness to work for a wage below the market wage
imposes an upper bound on workers’ ability indicating the worker is a lemon (Janet 1984). The
adverse selection model to provide an efficient explanation for involuntary unemployment firms
should be unable to observe work effort and pay piece rate after hiring workers or firing worker
if output found to be low.

6HR ECONOMICS
Labor market segmentation: The shirking model of efficiency wage provides rationale for
existence of dual labor market. In a dual labor market, utility among similar workers differ
across the jobs in primary and secondary labor market. The proposed hypothesis states that labor
market can be categorized into two groups (Antonelli and Quatraro 2013). Primary labor market
characterized by internal labor market and high wage and secondary labor market comprising of
low paying jobs where there is little or no room for advancement. The main objection to the
argument of segmented labor market is that if workers in secondary sector are envy of primary
sector and they are as productive as primary then wages in secondary labor market should be
lower to the level of equilibrium wage (Katz 1986). Empirical evidences suggest the high paid
workers in the primary sector are show a high degree of responsibility and take independent
action in part of the employee. Low paid job in the secondary market on the other hand are
subject to supervision. The efficiency wage, which is above the equilibrium wage, creates
difference in utility between jobs in primary and secondary labor market causing job loss costly
in the primary sector (Alt and Iversen 2017).
The famous automobile company moved to a high wage to lower the turnover rate.
Working in assembly lines is an awful job for most of the workers. This led to the problem of
high turnover rate. High turnover is costly for any company. Company needs to train a new
person for working in assembly lines and then engages that person to the line of work. During
the learning process, the worker is generally slow compared to others. Henry Ford paid US $5
wage per day to reduce the turnover and speed up working in assembly line (Roy 2016). The $5
wage to the Ford workers is what economists called efficiency wage. Paying workers age more
than the prevailing wage rate in the market for the same skill benefits a company in many ways.
Workers consider the fact that losing current job would lead them to a lower paying job. The

7HR ECONOMICS
higher wage was not successful completely in reducing turn over. Turn over still remains a
problem for the automobile manufacturers despite paying a high wage. This because some
workers were simply unable to adjust with the monotonicity of doing work in assembly line.
Therefore, they preferred to shift to the pay structure that offer them longevity. In addition, high
compensation rate became a big problem as their workforce and market shrank (abc.net.au
2018). The higher cost deterred their competitiveness. Efficiency wage is a successful marketing
strategy in a business model where competitors cannot follow the same.
The proposition that efficiency wage theory increases worker effort and motivation do
not hold for public sector. There is one view that workers in public sectors are generally found to
be less motivated following high wage. Studies found that workers are in public sectors are not
driven much by monetary motives (Sharif 2018). Instead, intrinsic rewards like scope for helping
other are more valuable to them. Even students who are willing to join public sector show less
interest towards monetary rewards compared to those willing to join private sector jobs (Taylor
and Taylor 2011). Past literatures found that the relation between payment to the workers and
public sector motivation is insignificant. This implies monetary rewards do not have any
influence on either to increase or decrease workers effort on workers’ performance in public
sector. This however does not mean wages or monetary rewards are completely irrelevant to all
the public sector employees. One study found that monetary benefits are important to many
government sector employees.
Comparison of salary structure between KFC and Mc Donald
This section compares the hourly wage rate for a sales representative working in KFC
and McDonald in Australia. McDoanld and KFC are two of the most popular fast food centers in
Australia. Both the centers pay a relatively higher wages to their workers to expand sales. The

8HR ECONOMICS
hourly wage rate for sales representative in KFC is $22.58 (Kfc.com.au 2018). Wage for the
same post in Mc Donald is $19.32 (Mcdonalds.com.au 2018). At present, the minimum wage in
Australia is $18.90 per hour (abc.net.au 2018). The workers in Mc Donald and KFC are already
getting wages above the minimum wage. The Mc Donald’s wage in Australia is even higher than
wages in many of the European nations. In France, the average wage rate roughly equals $12.00
per hour. The higher price and higher volume of sales allow them to offer wage above that in
United States. In Australia, Big Mac is charged 6 to 70 percent excess from its price in United
State. The higher wage in KFC and Mc Donald are also supported by rapid expansion of sales
volume of both the centers in Australia.
Figure 2: Efficiency wage in KFC and Mc Donald
(Source: as created by Author)
The Collins Food in Australia that is the biggest KFC’s chain here has been recorded a
revenue growth by 21.7 percent this year. The revenue has been expanded through rapid

9HR ECONOMICS
expansion of KFC’s business in Australia. Along with revenue growth, number of stores in
Australia. The company is focusing on improving its performance in Australia through
establishing further restaurants, operational management and profit margin
(businessinsider.com.au 2018). The higher paying sales representatives help in business
expansion by offering satisfactory service to the customers that promotes sales. The same is also
true for Mc Donald. In 2016, Mc Donald recorded sales of $5 billion in Australia despite intense
competition in the local market (Heffernan 2018). Mc Donald has experienced a steady growth
in Australia in terms of both sales and guest count.
Discussion of findings
As far as the findings suggests, the theory of efficiency wage offers a convincing
explanation for the relation between wage and work effort and workers’ efficiency. Paying a
higher wage is an efficient way to reduce turnover, shirking behavior and attract better quality
workers. A higher wage benefits both the employers and workers. Employers are benefitted from
increased work effort and resulted profitability. The higher wage increases workers affordability
to purchase more goods and services and hence, increase their standard of living. This provides
rationale for paying a wage above the equilibrium level. In real world, also many firms adapt the
strategy of efficiency wage (Cobb 2016). Henry Ford for example paid an efficiency wage to
reduce workers’ turnover. The fast food centers Mc Donald and KFC in Australia offered wage
above the set legal minimum wage. Both Mc Donald and KFC have experienced rapid growth in
the past few year. Higher wage to sales representative contribute to improve customer service
resulting in an increase in volume of sales and revenue.
In reference to theory and empirical evidences, wage can be used to motivate workers in
the workplace. However, firms should also consider the concept of backward bending supply

10HR ECONOMICS
curve. The backward bending supply curve suggest that the proposition that labor supply
increases with increase in work effort holds only up to a certain extent. It is true that with
increase in wage, the opportunity cost of leisure increases and hence, workers substitute leisure
with work hours. With increase in work effort productivity increases which is beneficial for the
firm. However, beyond a certain level workers prefer to enjoy leisure hours. After this point,
income effect dominates substitution effect resulting in a lower work effort with an associated
higher wage (Kitagawa, Ohta and Teruyama 2018). Labor supply curve thus bends backward and
firms no longer receive additional benefits by offering a higher wage. Firms thus should not raise
wage to a very high level.
The efficiency wage theory also ineffective in situation when all the competing firms pay
the same higher wage. Under such circumstance, higher wage only increases cost of the
operating firm lowering their competitive power. While increasing wage firms should also
consider the cost aspects as well. If increase in profitability is relatively lower compared to
increase in wage cost then net effect of increasing wage is negative and thus does not have any
effect on well-being of the firm.
Many studies found that monetary reward does not always work the primary motivational
factor. Beyond wage, other factors can be used to motivate worker. For example, employers can
allow some holidays to workers to enjoy their leisure times. This gives workers a break from
their monotonous jobs and increases productivity. Other benefits should also be provided to in
addition to direct salary. Such as medical facilities, travelling allowances and others. Several
facilities along with wage give workers a feeling of security and hence, increases productivity.
In order to encourage workers to perform well, wage can be used as an efficient tool.
However, following the theory of backward bending supply curve, wage should be set slightly

11HR ECONOMICS
above the market-clearing wage. Workers can also be provided other incentives to motivate
them. The monetary and other incentives should be based on evaluation of performance and
payment.
Conclusion
The essay analyzes relation between payment and performance in the workplace. The
theoretical and empirical literatures reviewed to critically evaluate the how wages are related to
workers’ performance. Paying a wage above the market-clearing wage without any legislation is
known as efficiency wage. In less developing nation, an obvious explanation for higher wage is
to improve health condition, which can increase productivity of workers. In context of developed
nations, the relevant models of efficiency wage include shirking model, turnover model and
adverse selection model. The shirking model and turnover model suggest that offering high wage
is an efficient way to reduce workers’ turnover and shirking tendency. High wage is also used as
a tool of attracting a better quality of workers. Another explanation of efficiency wage is given
by the theory of segmented labor market. The labor market segmentation states the dual market
(primary and secondary) exists with differing payment structure and utility.
Henry Ford paid its workers efficiency wage to lower workers’ turnover. In Australia,
KFC and Mc Donald also offer a wage to its sales representative above the legal minimum wage.
Efficiency wage has found to be beneficial for these companies. A contradictory theory of
efficiency wage is the theory of backward bending supply curve. Considering thus fact, it can be
concluded that firms should not solely depend on wage as a tool for motivating workers. Rather
other form of incentives should also be given to enhance performance of workers.

12HR ECONOMICS
References
abc.net.au. 2018. "Higher Wages, Fewer Jobs? It's Not That Simple". ABC News.
https://www.abc.net.au/news/2015-01-29/koukoulas-higher-wages,-fewer-jobs-its-not-that-
simple/6052010.
abc.net.au. 2018. "Minimum Wage Earners To Get An Extra $24 A Week". ABC News.
https://www.abc.net.au/news/2018-06-01/australian-minimum-wage-increased-by-3.5-per-cent/
9824282.
Alt, James, and Torben Iversen. "Inequality, labor market segmentation, and preferences for
redistribution." American Journal of Political Science 61, no. 1 (2017): 21-36.
Antonelli, Cristiano, and Francesco Quatraro. "Localized technological change and efficiency
wages across European Regional Labour Markets." Regional Studies 47, no. 10 (2013): 1686-
1700.
Booth, Alison L. "Wage determination and imperfect competition." Labour Economics 30
(2014): 53-58.
Brecher, Richard A., and Till Gross. "A minimum‐wage model of unemployment and growth:
The case of a backward‐bending demand curve for labor." International Journal of Economic
Theory (2014).
businessinsider.com.au. 2018. "Collins Foods, The Rise Of KFC And The Fall Of Sizzler".
Business Insider Australia. https://www.businessinsider.com.au/collins-foods-full-year-results-
kfc-sizzler-2018-6.

13HR ECONOMICS
Card, David, Ana Rute Cardoso, Jörg Heining, and Patrick Kline. "Firms and labor market
inequality: Evidence and some theory." Journal of Labor Economics 36, no. S1 (2018): S13-S70.
Cobb, J. Adam. "How firms shape income inequality: A rejoinder to Zardkoohi and
Bierman." Academy of Management Review 41, no. 4 (2016): 749-754.
Ehrenberg, Ronald G., and Robert S. Smith. Modern labor economics: Theory and public policy.
Routledge, 2016.
Georgiadis, Andreas. "Efficiency Wages and the Economic Effects of the Minimum Wage:
Evidence from a Low‐Wage Labour Market." Oxford Bulletin of Economics and Statistics75, no.
6 (2013): 962-979.
Heffernan, Madeleine. 2018. "Mcdonald's Australian Sales To Hit $5B". The Sydney Morning
Herald. https://www.smh.com.au/business/companies/mcdonalds-australian-sales-to-hit-5bn-
20161023-gs8i13.html.
Janet L. Yellen. “Efficiency Wage Models of Unemployment”. The American Economic Review
74, no. 2 (1984): 200-205
Johnson, Roger D. "The Supply of Labor." In Rediscovering Social Economics, pp. 105-120.
Palgrave Macmillan, Cham, 2017.
Katz, Lawrence F. "Efficiency wage theories: A partial evaluation." NBER macroeconomics
annual 1 (1986): 235-276.
Kfc.com.au. 2018. "KFC Australia | Home". Kfc.Com.Au. https://www.kfc.com.au/.

14HR ECONOMICS
Kitagawa, Akiomi, Souichi Ohta, and Hiroshi Teruyama. "Ranking and Long-Term
Unemployment in a Model with Efficiency Wages." In The Changing Japanese Labor Market,
pp. 65-115. Springer, Singapore, 2018.
Kool, Wouter, and Matthew Botvinick. "A labor/leisure tradeoff in cognitive control." Journal of
Experimental Psychology: General 143, no. 1 (2014): 131.
Lavoie, Marc, and Engelbert Stockhammer. "Wage-led growth: Concept, theories and policies."
In Wage-led Growth, pp. 13-39. Palgrave Macmillan, London, 2013.
Mcdonalds.com.au. 2018. "Mcdonald's Australia". Mcdonalds.Com.Au.
https://mcdonalds.com.au/.
Roy, Sucharita. "Efficiency Wage Models and Different Policy Implications." The International
Journal of Business & Management 4, no. 1 (2016): 268.
Sharif, Mohammed. Work Behavior of the World's Poor: Theory, Evidence and Policy: Theory,
Evidence and Policy. Routledge, 2018.
Taylor, Jeannette, and Ranald Taylor. "Working hard for more money or working hard to make a
difference? Efficiency wages, public service motivation, and effort." Review of Public Personnel
Administration 31, no. 1 (2011): 67-86.
Weiss, Andrew. Efficiency wages: Models of unemployment, layoffs, and wage dispersion. Vol.
1192. Princeton University Press, 2014.