Summary: In labor economics, the efficiency wage hypothesis argues that wages, at least in some markets, are determined by more than simply supply and demand. Specifically, it points to the incentive for managers to pay their employees more than the market-clearing wage in order to increase their productivity or efficiency. This increased labor productivity pays for the higher wages.

Because workers are paid more than the equilibrium wage, there will be unemployment. Efficiency wages are therefore a market failure explanation of unemployment – in contrast to theories which emphasize government intervention (such as minimum wages).

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“Economists call the theories that link productivity or the efficiency of workers to the wage they are paid efficiency wages.” That definition is from Oliver Blanchard’s textbook, Macroeconomics. I use that definition as a backbone for today’s thoughts on unemployment.

When a firm pays an employee above market-clearing wages, I call this an efficiency wage. The wage is higher than necessary to retain the employee so the wage gives the employee an incentive to stay and be productive since there are no alternate uses of time that pay more. Employees who are paid above market-clearing prices have a higher morale. I have always said, that “Employees who feel good about themselves are more productive.” What is the link between efficiency wages and unemployment?

Efficiency wages cause structural unemployment. In other words, the market does not clear because the pricing mechanism is broken. Wages can not adjust to market conditions so some workers who would contribute to the labor force find themselves out of a job at the higher wage. This is like the unemployment that results from the minimum wage.

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Reciprocity and Wage Undercutting

It is well-documented that employers refuse to hire workers who offer their services at less than the prevailing wage. The received explanation is that workers are motivated by reciprocity they desire to reward kindness and punish hostility. To refuse an outsider’s under-bid is viewed as a kind choice that is met with good effort; a low wage is viewed as an insult that is met with shirking. We have developed a general theory of reciprocity which in this paper is applied to a wage-setting game played by an employer and two workers. We show that when workers are motivated by reciprocity, equilibrium behaviour accords well with the aforementioned stylized facts.

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