Efficiency Wages and 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.