Efficiency Wage Hypothesis Analysis

This assignment delves into the theory of efficiency wages, examining various models such as shirking, adverse selection, and worker turnover that explain why paying higher wages can benefit firms. It analyzes relevant literature and empirical evidence supporting the hypothesis, particularly in Australia. The assignment highlights Henry Ford's successful implementation of this policy and recommends its adaptation by the Fair Work Commission while considering cost implications.

Running head: HUMAN RESOURCEE ECONOMICS
Human Resource Economics
Name of the Student
Name of the University
Author note

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Table of Contents
Introduction......................................................................................................................................2
Literature review..............................................................................................................................2
The theory of efficiency wage.....................................................................................................4
Efficiency wage with labor market segmentation.......................................................................6
Backward bending labor supply curve........................................................................................6
Empirical evidence and practical applicability of efficiency wage.................................................7
Recommendation and Conclusion...................................................................................................8
References......................................................................................................................................10

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Introduction
The factors used in production process earns a return. Labor is an important factor of
production and receives wage as remuneration. The forces of demand and supply in the labor
market generally determine the wage paid to the employees. The structure of wage and
employment is a crucial determinant of wage. Factors influencing the productivity of labor in
private as well as in public have contested long. Wage is a primary influencing factor of labor
supply and productivity. A wage above the equilibrium wage generally creates an oversupply of
labor and hence unemployment. In the presence of strong bargaining power of union employers
often forced to set wage above the equilibrium wage. When employers pay wage above
equilibrium wage to enhance productivity without any force then it is called efficiency wage.
One contradictory theory of efficiency wage is that of the theory of backward bending labor
supply curve. The theory suggests, increases in wage increases labor supply to a certain level.
Beyond that, point labor supply decreases as labor gives priority to leisure above their labor time.
In this paper, the theory of efficiency wage is discussed and the relation between pay and
performance is analyzed. The issues are draw from relevant literature and related with labor
policies of a well-established company in Australia.
Literature review
In literature, the structure of wage and differences in the prevailing wage level is widely
discussed because of its long held implications on living standard of labors and productivity.
With passes of time, the structure of wage and employment has changed in industries. Different
wage theories and models are proposed to explain the incidence of wage and examine those
theories with some practical evidences.

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The theory of equitable wage is one of the important theories in literature of wage
structure. The theory suggests that existing poverty and inequality contributes to increasing wage
gap among the labor force. The differences in wage here are explained with discrepancies in the
job profile, in firms’ structure, differences in economic condition and development status and
composition of society (Schmitt, 2013). The equitable wage distribution is seen as a way of
mitigating inequalities in these countries. The theory has little to do with efficiency of workers
and firms’ productivity and this opens a door to critic of this theory.
Pay for performance model provides an argument for wage inequality on ethical ground.
The high payment scheme gives worker incentive to give greater work effort and enhance
productivity. Overtime the workers develop their skills as encouraged by the higher wages. The
skilled and good quality workers increase overall productivity of firms. Many literatures support
the pay for performance model. This theory suggests when workers receive a high wage then an
improvement in performance in realized. However the ability of the worker within firms differs
and this difference in skills results in inequality in wage payment. Here wage is paid according ti
their performance. The argument of this model is quite similar to the theory of efficiency wage.
Scholars had devoted much of their time to explore wage several wage theories that exit
in different economies. One such theory counters the proposed theory of equal wage
distribution. The counter arguments indicate that the theory of equal distribution of wages may
seem appealing from a social perspective of equality but it not economical at all (Coşar, Guner
& Tybout, 2016). The equal wage reduces the incentives of additional work effort. In some
situation it is reasonable to exit an inequality of wage. There are some common trends of wage
inequality that has proven beneficial for the firm as well as for the workers.

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The theory of efficiency wage
Efficiency wage is a above equilibrium wage that is paid to increases efficiency of
laborers. Unemployment is a situation where a surplus labor exists in the labor market. The
legislated minimum wage leads to an excess supply of labor as labor demand reduces in response
to a high wage. Both minimum wage and efficiency wage is set above the equilibrium level
however employers’ motivations are different in the two situations. According to this theory,
high wage encourages workers to put more effort and increases profitability of the firms
operation (Du Caju et al., 2015). Here, firms are considered to be better off from offering a high
wage. There are different theoretical models giving different rationale for paying a high wage.
The widely discussed models are as follows.
Model of adverse selection
In a firm, the wages offered to the workers determine the workers’ quality. Firms intend to
attract most productive workers in their labor force. The quality of the workers cannot be
assessed by the firms ideally. Firms use the tool of wage to have a better quality workforce. It is
assumed that when a high wage is offered then better quality workers will be interested for the
job than they otherwise are (Guerrazzi & Sodini, 2017). Low wage reduces the work incentive
and skilled workers may find it as a state of underemployment. The claim of efficiency wage is
supported when wage turns out an important attribute of workers quality.
Turnover model
The workers’ turnover model points toward the inverse relationship between workers
between turnover of workers and a relatively high wage. There are several reasons for which
workers decide to quit their jobs. Workers may find a mismatch between the job profile and their

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skill, may want to relocate in some other industries and more often to get a better payment and
the like. Wages or work incentive here is one crucial factor here. In deciding whether to quit
their jobs, workers do costs benefit analysis of staying or quitting their existing jobs (Pashardes,
Polycarpou & Polycarpou, 2015). When opportunity cost of quitting a job is higher, they decide
to continue in their jobs.
Firms always want to make the turnover rate as minimum as possible. It is beneficial for
firms to retain their existing workers than to hire fresh workers and train them. In order to retain
productive and experienced workers firms offer a high wage, a wage above that prevail in the
market.
The shirking model
Productivity in an industry is highly depended on the work effort given by the workers. It is at
the discretion of workers regarding how much effort to put. Firms may enforce monitoring
devices or employ supervisors to monitor the work effort but monitoring is costly and lacks
transparency. Even when worker who caught shirking their responsibilities are driven away from
their jobs it is not possible to completely cease the practice (Roy, 2016). Therefore, it is better to
incentivize the workers such that losing current jobs entails enough opportunity cost that workers
put forward their best effort. Wage is the form of incentive and the model thus support the
hypothesis asserts in efficiency wage theory.
Health of worker
This is another argument in favor of paying a high wage to workers particularly
applicable in developing or underdeveloped countries. In poor countries, equilibrium wage
determined in the market may not be sufficient that the workers can afford a healthy and

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nutritious diet. The health condition of workers has direct effect on productivity. Therefore,
employers in these countries consider to give a wage such that they can have healthy diet and
improves productivity (Verhoogen, 2015). In developed countries the argument is not much
applicable as most of the workers there receive sufficient wages to carry out healthy diet.
Efficiency wage with labor market segmentation
The labor market segmentation theory is rooted in the practice of wage discrimination as
evidenced in twentieth century. Since then different levels of wage and job securities exist in the
labor market. In a segmented labor markets different there are different sub market in the labor
market each having a different condition. However, in real world the distinction among the sub
markets are not clearly visible and often overlap. Three well known segments are regional
market, professional market and branch market. Existence of a dual economy is the basis for
existence of labor market segmentation. The dual economy is characterized with a high income
and low income sectors.
Primary and secondary labor market segment are two other categories of labor market
segmentation. Laborers in the secondary sector generally do not enter in the primary sector as
characterized by senior job posts. In the secondary labor market segment workers hyave low
wage income and works in poor work environment (Stiehl et al., 2017). In this segment high
wage acts as a tool to improve worker condition and prevent workers’ turnover.
Backward bending labor supply curve
The efficiency wage theory as limited explanation for backward bending labor supply
curve. In the short run an increase in wage generally increases labor supply. The wage effect can
be decomposed into income effect and substitution effect same as price effect. The substitute to
work effort here is leisure. Beyond a critical point increased wage encourages workers to

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substitute more leisure in place of work effort. This makes the labor supply curve backward
bending.
Figure 1: Backward bending labor supply curve
(Source: Pashardes, Polycarpou & Polycarpou, 2015)
Empirical evidence and practical applicability of efficiency wage
Apart from derivation of theoretical models of efficiency wage studies have conducted to
empirically verify the efficiency wage assertion. Studies during 1980s and 1990s failed to find
strong support in Australian labor market. However, some evidences are there that support
efficiency wages in favor of voluntary unemployment in the nation. A highly contested field of
research is worker motivation in public sector and prevailing wages (Booth, 2014). Studies
reveal that wages in private sector differ significantly from that in public sector. Empirical
evidences find a high elasticity value of Public sector motivation implying motivation plays an
important role in affecting work effort.

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The famous automobile company Henry Ford practically implement the theory of
efficiency wage. In 1914, Ford introduced a wage rate of five dollar. It is twice the average wage
rate of automakers at that time. Ford’s decision of offering a high wage to its workers give
relevance to the theory of efficiency wage for determination of employment. The policy has
proved effective for raising Ford’s productivity and associated profitability. Earlier Ford was
paying a wage of $2.34 for working nine hour per day. The wage level doubled to become $4.80
per day (Wilson, 2014). The higher wage in Ford created pressure on its competitors. Many of
them tried to match the wage level of Ford but utterly failed and some of them went bankrupt.
This was a surprising move of Ford while compared to other manufacturers setting wage at least
possible figure. In exchange of the high wage, Ford believed to retain workers committed to high
quality work. Ford considered the price rise to be necessary to have workers to handle the
pressure from business expansion. Another rationale for giving high wage to the workers to raise
the purchasing power the workers so that they can increase their demand. In 1919, Ford again
revise their wage and set the minimum wage as $6.00. Today also, Henry Ford paid a high wage
to improve efficiency of workers.
Recommendation and Conclusion
The Fair Work Commission should have close look the relevant theories of efficiency
wage and employment. Implementation of efficiency wage is beneficial when giving extra
payment increases the productivity of the workers. Looking at the experience of Henry Ford,
which benefitted from paying their workers a high wage Fair Work Commission, can adapt this
policy. However, the organization should also consider the increasing cost of resulted from high
wage. The commission should set wage to the level, which is slightly above the market
equilibrium level while also considering the aspect of cost.

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The report analyzes efficiency wage hypothesis with relevance to literature and empirical
evidences. There are several theoretical model that explains why giving high wage may prove
beneficial for firm. The commonly known models are shirking model, mode of adverse selection
and worker turnover model. Literature finds some support of the theory in Australia. However,
for public sector motivation plays a much bigger role than efficiency wage. Henry Ford has
already implemented the theory long before and enjoys positive fruits of this policy.

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References
Booth, A. L. (2014). Wage determination and imperfect competition. Labour Economics, 30, 53-
58.
Coşar, A. K., Guner, N., & Tybout, J. (2016). Firm dynamics, job turnover, and wage
distributions in an open economy. The American Economic Review, 106(3), 625-663.
Du Caju, P., Kosma, T., Lawless, M., Messina, J., & Rõõm, T. (2015). Why firms avoid cutting
wages: Survey evidence from European firms. ILR Review, 68(4), 862-888.
Guerrazzi, M., & Sodini, M. (2017). Efficiency-wage competition and nonlinear
dynamics. Communications in Nonlinear Science and Numerical Simulation.
Pashardes, P., Polycarpou, A., & Polycarpou, A. (2015). A backward-bending and forward-
falling semi-log model of labour supply (No. 03-2015). University of Cyprus Department
of Economics.
Roy, S. (2016). Efficiency Wage Models and Different Policy Implications. The International
Journal of Business & Management, 4(1), 268.
Schmitt, J. (2013). Why does the minimum wage have no discernible effect on
employment?. Center for Economic and Policy Research, 22, 1-28.
Stiehl, E., Shivaprakash, N., Thatcher, E., Ornelas, I. J., Kneipp, S., Baron, S. L., & Muramatsu,
N. (2017). Worksite Health Promotion for Low-Wage Workers: A Scoping Literature
Review. American Journal of Health Promotion, 0890117117728607.
Verhoogen, E. (2015). Essays on External Conditions and Wage Setting within Firms. Members-
only Library.

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Wilson, J. M. (2014). Henry Ford vs. assembly line balancing. International Journal of
Production Research, 52(3), 757-765.