Efficiency Wages

In labor economics, efficiency wages are a level of wages paid to workers above the minimum wage in order to retain a skilled and efficient workforce. Efficiency wage theory posits that an employer must pay its workers high enough so that workers are incentivized to be productive and that highly skilled workers do not quit. Efficiency wages may also be paid to workers in industries that require a great deal of trust—such as those working in precious metals, jewels, or finance—to help ensure that they remain loyal.

Efficiency wage theory helps explain why firms seem to overpay for labor by arguing that these increased wages actually boost overall productivity and profitability for a firm over the long run.

Efficiency wages were theorized as far back as the 18th century, when classical political economist Adam Smith identified a form of wage inequality in that workers in some industries are paid more than others based on the level of trustworthiness required. For instance, Smith identified that those working for goldsmiths or jewelers, while often just as skilled as those working for blacksmiths or other craftsmen, were paid relatively more per hour.1 Smith supposed that this must be due to the need to incentivize such workers from stealing these more valuable products.

In more modern contexts, efficiency wages refer to the fact that many employers do not slash wages to the minimum wage, even in the face of competition from other firms or during periods of recession when an eager supply of unemployed labor is abundant. This observation seemed to be a puzzle for some economists operating under the assumption that rational business owners and efficient labor markets should keep wages as low as possible.

The solution to this puzzle is that efficiency wages solve a principal-agent problem, so that without such high wages, employers would be hard-pressed to keep their workers productive and loyal.

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