Question

Explain why employers pay a lower efficiency wage when unemployment is high. How would the efficiency wage change in an economy if it became easier to monitor the work that employees did? Other than to incentivise workers to put in effort, can you think of any other reasons why wages might be higher when unemployment is low (i.e. an upward-sloping wage-setting curve)?

Answer 1

Efficiency wage can be defined by the relation between the effort exerted by an individual unit of physical labor and the real wage rate of the labor market. An increase in wage rate leads to an increase in the effort of the physical labor.

Thus taking effort as function of real wages: E= f(w)      {where E = Effort, w = real wage rate}

• Employers pay a higher wages to induce workers to increase their efforts which leads to an increase in production. However, the workers will put in harder efforts only when the wages in firms (other than in which they are working) are lower and the market is experiencing a high unemployment rate. However, if other firms are paying much higher than the current one & there is a situation of high unemployment, then the chances of the worker shirking in their current job become much lesser even if their work is not monitored regularly. In this scenario, the probability of the workers getting another job is very much less and thus they avoid any actions that would make them loose their current job. This induces the firm, to lower their efficiency wages, which reduces their cost and thus maximize their profits.

• If it becomes easier to monitor the work that employees do, though this would add on to the additional cost of the employer, but the benefits from the same would be more. This would be zero-incentive for the worker that would try to shirk (assuming high unemployment). In such case, the efficiency wages would be just equal to the reservation wage in the labor market. An increased effort would increase the efficiency rate but at a decreasing rate.

• Firm’s pays higher wages when the unemployment rate is low also beacuse:

1. Higher wages creates a sense of understanding and trust among the workers and the employer. This induces the worker to further increase their efforts thereby maintaining long-term relationships.

2. Generally workers with high reservation wages (the minimum wage rate at which the workers are willing to work) are considered to have better skills. Thus, higher wages increases the probability of any firm to get the best ones among the available pool of workers.

3. In especially developing economies, a higher efficiency wage would increase the consumption capacity of the worker, thus a better nutrition status and better standard of living.