Efficiency Wages

What Are 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.

Key Takeaways

  • Efficiency wages refer to employers paying higher than the minimum wage in order to retain skilled workers, increase productivity, or ensure loyalty.
  • Efficiency wage theory helps explain why firms are reluctant to cut wages even in the face of increased competition or during economic downturns.

Understanding Efficiency Wages

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. 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.

Why Pay Efficiency Wages?

Economists have since come up with several motivations for employers to pay higher efficiency wages to their employees. The most common include:

  • Reduce employee turnover: Higher wages discourage workers to quit. This is especially important if hiring and training new workers is a time-consuming and costly pursuit.
  • Raise morale: Similarly, an efficiency wage can keep workers happier and minimize the number of disgruntled employees who can bring down morale among others and slow down production.
  • Increase productivity: Higher wages lead to more productive workers who produce relatively more goods per hour and show greater effort. These wages also reduce so-called shirking (being lazy on the job) and cut down on absenteeism.
  • Attract and retain skilled workers: While unskilled workers may be viewed as somewhat interchangeable from the perspective of management, highly skilled workers are often in higher demand and shorter supply.
  • Trust and loyalty: Higher-paid workers tend to be more loyal to a company and are far less likely to steal or undercut the company's bottom line.

Henry Ford is well-known for paying above-market wages to his employees and is often seen as a good example of efficiency wage theory in action. In January 1914, Ford increased the minimum wage among all of his employees to $5 per day for an eight-hour workday (around $17 per hour in 2021 dollars), roughly double what they had been paid previously.While many skeptics at the time asserted that this would be financial ruin for the carmaker, the move actually greatly increased output and profits for Ford.

Efficiency Wage Theory

While the efficiency wage concept dates back a couple of centuries, it was only formalized by economists during the second half of the 20th century. Notable examples include Joseph Stiglitz and his work on shirking. Working with colleagues, Stiglitz proposed that, when employment is high, workers that are dismissed can easily find new employment. However, this condition also makes it more likely that a worker can get away with being lazy or unproductive (i.e., "shirk on the job"). But, since shirking reduces a firm's profitability, employers are incentivized to raise wages in order to counteract this and motivate their workers. Stiglitz won the Nobel prize in economics in 2001, in part for this work.

George Akerlof, another Nobel prize winner, also worked on efficiency wages by advancing the hypothesis that wages remain "sticky," even in times of economic malaise, whereby employers do not reduce the salaries of their employees. Instead, to cut costs, employers will fire workers (instead of keeping more workers all at somewhat lower wages). However, this increases the rate of involuntary unemployment. Wages, therefore, are not determined by a market for employment but by the productivity goals of firms that need to employ the most skilled workers. Akerlof, working with Janet Yellen, argued that a company can best economize on training and hiring costs by laying off some workers when the economy struggles instead of cutting wages for all of its employees across the board.

Article Sources
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  1. Kevin M. Murphy & Robert H. Topel. "Efficiency Wages Reconsidered: Theory and Evidence. In Advances in the Theory and Measurement of Unemployment," Pages 204-240. Palgrave Macmillan, London, 1990.

  2. Stiglitz, Joseph E. "Alternative Theories of Wage Determination and Unemployment in LDC'S: The Labor Turnover Model." Quarterly Journal of Economics, vol. 88, no. 2, 1974, pp. 194-227.

  3. Danthine, Jean-Pierre, and Kurmann, André. "Efficiency Wages Revisited: The Internal Reference Perspective." Economics Letters, vol. 90, no. 2, 2006, pp. 278-284. 

  4. The Henry Ford. "Ford's Five-Dollar Day."

  5. The Nobel Prize. "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2001."

  6. George A. Akerlof and Janet L. Yellen. "Efficiency Wage Models of the Labor Market." Cambridge University Press, 1986.

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