4.14: Efficiency Wages and Unemployment

Efficiency wages are wages set above the market-clearing level. The market-clearing wage is the rate at which the quantity of labor supplied equals the quantity of labor demanded.

One of the reasons firms may offer efficiency wages is to encourage better performance from workers. In situations where employers cannot directly observe how much effort each employee puts in, paying the market-clearing wage may not be enough to ensure that workers maintain productivity. To address this issue, firms offer higher wages. The higher wage makes the job more valuable to employees. This reduces the likelihood that workers will shirk their responsibilities. The risk of being unemployed and losing a well-paying job serves as a strong motivation for workers to maintain.

However, this approach also leads to unintended consequences. When wages are set above the market-clearing level, more people are willing to work at that wage, but firms are not willing to hire as many workers. This mismatch results in unemployment. The presence of unemployed workers, in turn, reinforces the value of the job for those who are employed, further supporting the firm's strategy of using high wages as a disciplinary tool.

Thus, while efficiency wages can improve productivity, they may also contribute to unemployment.

When firms can’t fully monitor effort, some employees may shirk. In such cases, paying the market-clearing wage—the wage at which labor demand equals labor supply—does not provide enough incentive to ensure productivity. Firms respond by offering a higher wage to increase effort.

However, when wages are high, more people are willing to work. Yet firms hire fewer workers at that wage, creating an excess labor supply. As a result, unemployment emerges.

This resultant unemployment now increases the cost of individual worker shirking. This is because getting fired for shirking results in the employee facing an increased amount of time unemployed while looking for a new and more scarce job. So, the efficiency wage model explains that a certain level of unemployment happens when firms try to prevent shirking in an economy where monitoring effort is difficult.

This explanation captures one reason firms may pay an efficiency wage—a wage above market-clearing to increase worker productivity. The threat of being unemployed makes high wages effective in sustaining worker discipline when monitoring effort is difficult.