Analysis of Human Resource Economics: Efficiency Wage and Labor Market

This essay delves into the field of human resource economics, focusing on the efficiency wage theory and its implications for labor markets. It explores how paying wages above the equilibrium level can enhance worker productivity, motivation, and reduce turnover. The essay reviews existing literature and examines various models supporting the efficiency wage theory, including those related to worker health, adverse selection, turnover, and shirking. It also discusses the concept of labor market segmentation and presents empirical evidence, including the historical example of Henry Ford's wage strategy. Furthermore, the essay addresses the backward bending labor supply curve, which challenges the indefinite increase in labor supply with wage increases. The conclusion emphasizes the importance of considering all relevant theories and empirical evidence when determining wages to optimize worker performance and control costs. The paper includes multiple references to support the arguments and findings presented in the essay.

Running head: HUMAN RESOURCE ECONOMICS
Human Resource Economics
Name of the Student
Name of the University
Course ID

1HUMAN RESOURCE ECONOMICS
Introduction
Workers receive wage in return of their productive performance. In the labor market,
demand and available supply of labor determine the payable wage to workers. Market
equilibrium wage though indicates an efficient labor market scenario; employers however often
agree to pay an above equilibrium remuneration to enhance performance of workers. When a
higher wage is paid by the employers without any external force then this is called efficiency
wage (Ehrenberg & Smith, 2016). Many economic theories though support the rationale of
efficiency wage, there are some contradictory theories as well. The theory of backward bending
labor supply curve contradicts the theory efficiency wage after a threshold level of wage.
Review of past literature
Many studies have been conducted to analyze the wage structure in specific industries
and existing differences in wage level. Productivity of workers and standard of living differ
depending on their wage. Industries undergone several changes over time. With change in
industry’s structure employment trend changes and so is the wage (Shields et al., 2015).
Different theoretical models are developed to study the wage structure. The theories are then
reasserted with reference to real world evidences.
The inequality in wage structure is explained with a model called pay for performance.
The model suggests that higher wage indicates a higher incentive to work which induces workers
to put greater effort. This improves performance of workers in the form of increased
productivity. Skills of workers improve overtime in response to high wage (Altman, 2015).
Workers ability differs within firm resulting in a wage inequality across different industries.

2HUMAN RESOURCE ECONOMICS
A proposition in favor of equality in wage distribution is made by the equitable wage
theory. According to this theory poverty and income inequality increases the wage gap among
workers. The theory explains wage difference for differing job profile, state of the economy and
difference in firms’ structure. The equitable wage theory aims to reduce wage inequalities across
nations (Sikka, 2015) The theory might be appealing from perspective of social welfare but the
same is not true when viewed from an economic perspective. The scheme of equal wage
eliminates incentive for extra work leaving no room for improving productive performance.
Efficiency wage theory
Several factors contribute to persistent unemployment in the labor market. These factors
include legislation of minimum wage, people searching for new jobs and labor union bargaining.
Another effective explanation of above equilibrium wage and resulted unemployment is given by
the theory of efficiency wage (Dunlop & Segrave, 2016). In the economic literacy, the theory of
efficiency wage focus on exclusively explaining the relation between performance and pay. The
theory suggests that firms should give workers a wage higher than equilibrium wage. A higher
wage increase productivity, cohesiveness in the workplace, the sense of loyalty and
responsibility among the workers and reduces tendency of shirking. In contrast, wage below the
market clearing wage contribute to dissatisfaction among the workers leading to a negative
attitude towards work (Weiss, 2014) This hampers productivity and results in high turnover. The
efficiency wage theory is again supported by difference theoretical model which are briefly
discussed below
Health of workers: The simplest explanation of efficiency wage theory is improvement in health
of workers. This version of efficiency wage theory shows the direct linkage between health of
workers and offered wages. A high paid worker is able to afford a more nutritious diet. The

3HUMAN RESOURCE ECONOMICS
healthy diet has a favorable effect on productivity of workers. Healthy and nutritious diet helps
to improve workers’ health making them more productive. It is preferable for employers to pay a
high wage and retain healthy group of workers instead of paying equilibrium wage that is
insufficient to meet the demand of nutritious diet. The lower wage thus leave the workers to
suffer from poor condition of health hampering productivity.
The explanation though sounds effective but it is not applicable for workers belonging to
rich countries. In developed nations, equilibrium wage is high enough that the workers can easily
afford a balanced and healthy diet. Firms in these countries do not bother at all about the fact that
paying a high wage beyond the equilibrium wage would affect workers’ health in any way. This
explanation rather is more relevant for poor developing countries (Stiglitz & Rosengard, 2015).
In poor countries, marginal increase in wage can make a notable difference in health condition of
workers. Most of the firms in Africa fears that cutting wage of the workers could have a
significant adverse effect on workers’ health.
Adverse selection model: Wage is an important determinant of quality of workforce. There are
no such tools that can assess workers’ quality clearly. If firms offer a higher wage, then this
attract better quality and talented workers for a given job position. Lower wage on the other hand
discourage better quality workers. Higher wage thus seems to be a useful way to attract talented
pool of workers.
Model of worker turnover: The model suggests that higher wage increases opportunity cost of
leaving the current job This in turn helps employers to retain workers for a longer period than
otherwise be. The turnover model of efficiency wage indicates an opposite relation between
wage and workers’ turnover in a firm. High turnover is costly for a firm because firms need to

4HUMAN RESOURCE ECONOMICS
spend a lot of time and money trained newly joined workers (Zhang, 2018). It is therefore fairly
reasonable for the company to pay a higher wage and retain the experienced workers.
Shirking model: Productivity of a worker depends on the work effort that workers put. Following
a lower wage workers have a tendency to shirk their job responsibility. Monitoring and
supervising work effort to each of workers is costly. Higher wage provides workers incentive to
put higher effort (Card et al., 2018). With the fear of losing a high paid job workers reduce
shirking behavior and thus support higher payment for improving performance.
Labor market segmentation
The theory of labor market segmentation originated from wage discrimination practice of
wages in twentieth century. Segmented labor market is characterized as a market with different
sub markets each with a different condition. In real word however differences in different
submarkets are not clear rather overlapping. Regional market, branch market and professional
markets are the three well segmented sub markets (Alt & Iversen, 2017). The dual economy
prepares the basis of labor market segmentation. The dual economy is divided into two segment
– high income and low income segment.
Another two clear segmented markets are primary and secondary market. The primary
labor market segment is characterized by high paying jobs with senior posts. The primary
segment remains clearly distinct from that of the secondary segment. In such segmented labor
market wage is used as an important tool for improving condition on workers and reducing
turnover.
Empirical evidence of efficiency wage

5HUMAN RESOURCE ECONOMICS
Several studies attempted establish relevance of efficiency wage theory with empirical
evidences. Studies on Australian labor market during the period of 1980 and 1990 could not find
supporting evidences. Some evidences however has been found supporting efficiency wage
theory on ground of prevailing voluntary unemployment in Australia (Preston, 2018).
Considerable time has been invested to find out the connection between wage and motivation of
workers in public sectors. Evidences are found about significant differences in wage structure
between public and private sector. Past literatures found that in public sector wage is not the only
factor affecting work effort. It is motivation to the workers that influences work effort and
productivity (Belle, 2013). The elasticity of work effort with respect to motivation is found to be
considerable higher.
In real world many industries follow the theory of efficiency wage to boost workers’
productivity. One such example is efficiency wage paid by Henry Ford. The tradition started
since 1914. Ford then offered a wage of $5, twice that of average wage of automakers during that
time. The higher wage effectively increased productivity and profitability of the company. The
increased wage paid by Ford raised competitive pressure on competitors. In an attempt to
increase wage many automobile companies went bankrupt. The company considered higher
wage as an effective wage to retain high quality work. Ford again revised the wage to $6.00 per
day (Cobb, 2016). The trend of high wage continued till today and workers in Ford receive a
considerably high wage.
Backward bending labor supply
The theory of efficiency wage is often criticized on the ground that labor supply does not
increase indefinitely with increase in wage. Supply initially increases with wage but only up to a

6HUMAN RESOURCE ECONOMICS
certain point (Sharif, 2018). After the critical level, workers prefer leisure hours to the work
effort and labor supply starts to decline questioning the theory of efficiency wage.
Figure 1: Backward bending labor supply curve
(Source: Sharif 2018)
The backward bending labor supply curve is a graphical tool indicating real world
relation between wage and work effort. Increase in wage after a certain limit labors starts
substituting work hours with leisure. This shows that higher wage lead to a decline in supply of
labor. The can be explained in detail with labor leisure trade off. The basis of the trade-off is the
comparison between received wage for each working hour and the satisfaction enjoyed during
unpaid time (Weiss 2014). After a certain limit labors prefer leisure hours more to work effort
and reduces labor supply causing the labor supply curve to bend backward after the threshold
limit.
Conclusion
Fair Work Commission should consider all the theories and evidences related to
employment and wage. It is beneficial for the company to offer a higher wage if and only if it

7HUMAN RESOURCE ECONOMICS
improves performance of workers. Following Henry Ford’s experience, it can opt the strategy of
paying a higher wage. Additionally, the company should consider resulted increase in production
cost from higher wage. The final wage should be set at a level that is beneficial for increasing
workers’ productivity with cost remaining under control.

8HUMAN RESOURCE ECONOMICS
References
Alt, J., & Iversen, T. (2017). Inequality, labor market segmentation, and preferences for
redistribution. American Journal of Political Science, 61(1), 21-36.
Altman, M. (2015). Cooperative organizations as an engine of equitable rural economic
development. Journal of Co-operative Organization and Management, 3(1), 14-23.
Belle, N. (2013). Experimental evidence on the relationship between public service motivation
and job performance. Public Administration Review, 73(1), 143-153.
Card, D., Cardoso, A. R., Heining, J., & Kline, P. (2018). Firms and labor market inequality:
Evidence and some theory. Journal of Labor Economics, 36(S1), S13-S70.
Cobb, J. A. (2016). How firms shape income inequality: A rejoinder to Zardkoohi and
Bierman. Academy of Management Review, 41(4), 749-754.
Dunlop, J., & Segrave, M. (2016). The theory of wage determination. Springer.
Ehrenberg, R. G., & Smith, R. S. (2016). Modern labor economics: Theory and public policy.
Routledge.
Preston, A. (2018). The structure and determinants of wage relativities: evidence from Australia.
Routledge.
Sharif, M. (2018). Work Behavior of the World's Poor: Theory, Evidence and Policy: Theory,
Evidence and Policy. Routledge.
Shields, J., Brown, M., Kaine, S., Dolle-Samuel, C., North-Samardzic, A., McLean, P., ... &
Plimmer, G. (2015). Managing employee performance & reward: Concepts, practices,
strategies. Cambridge University Press.

9HUMAN RESOURCE ECONOMICS
Sikka, P. (2015). The hand of accounting and accountancy firms in deepening income and wealth
inequalities and the economic crisis: some evidence. Critical Perspectives on
Accounting, 30, 46-62.
Stiglitz, J. E., & Rosengard, J. K. (2015). Economics of the public sector: Fourth international
student edition. WW Norton & Company.
Weiss, A. (2014). Efficiency wages: Models of unemployment, layoffs, and wage dispersion (Vol.
1192). Princeton University Press.
Zhang, W. B. (2018). Economic Growth Theory: Capital, Knowledge, and Economic Stuctures.
Routledge.