In the context of the search model of the labour market, Peter Diamond (1971) raised the following critique: Firms have no incentive to offer a wage higher than the reservation wage. Discuss.
Economic theory may initially have us believe that firms shouldn’t offer a higher wage than the reservation wage of workers. If they did so then another firm could enter the market, charge below the reservation wage, have lower costs, sell output at a lower price and capture the market. Yet the theory of efficiency wage provides another story, that higher productivity can offset the cost of higher wages (so that a firm offering w>w* isn’t competed out of the market), and more importantly that a firm must offer a wage greater than the reservation wage in order to operate.
Carlin and Soskice propose the two fundamental reasons for this are to reduce turnover costs (Salop) and to reduce shirking (Shapiro-Stiglitz). The Salop model shows that it may pay firms to pay an above equilibrium wage in order to retain workers (assuming that a percentage of them left as a result of higher wages at other firms, or because they would rather leisure than work at the going rate), to prevent having to pay training costs for new workers. Additionally there would be a cost associated with searching for new workers, so it would benefit a firm to retain current workers, and they would be willing to pay an efficiency wage in order to gain from this benefit.
The Shapiro-Stiglitz model is used to show that workers have an incentive to shirk (i.e. not work), and this incentive is greater if the wage is equal to the reservation wage because at this point workers are indifferent between working and not working, thus they will shirk and get caught with a probability q. The greater the efficiency wage paid by a firm, the greater the cost to an individual who loses his job as a result of being caught shirking. Therefore higher efficiency wages will lead to a reduction in shirking, increasing the productivity of firms, leading to greater output, permitting them to afford this wage premium. However, it isn’t necessary for them to pay efficiency wages if unemployment naturally exists (in an imperfect world with market failures) and unemployment benefits are low. If this were the case then workers may fear losing their jobs, because without their wage they would be earning nothing, and therefore they exert effort to retain their job. Furthermore, a firm could offer a small efficiency wage but then spend a lot of money investing in monitoring techniques to discourage workers from shirking.
A less explicit, but plausible incentive for firms to offer an efficiency wage is because it may increase the morale of workers, who feel valued by the firm, and therefore work harder, increasing their productivity and thus firm output. If output rises significantly then the higher revenue will offset the increased labour costs.
Roff and Summers examined the case when Henry Ford increased his wages to $5 in 1914 at his automotive factory, the reason for doing so was not because he was unable to attract enough labour (there were often queues of labourers outside the production factory) or because he wasn’t able to attract workers of the appropriate skill (the factory was de-skilling, so if anything wages should have been falling), but to increase the productivity of workers through a morale boost and reduce labour turnover which had reached 370% in 1913. Ford saw the effect of an efficiency wage when he visited his British plant, in Manchester, where the wage was 3 pounds instead of the going 1.5, as a result there were “substantial productivity benefits” (Roff and Summers). The effect was for the turnover rate to fall from 370% in 1913 54% in 1914 and 16% in 1915 (Slitcher) supporting evidence of a gain in the Salop-efficiency-wage form; although an exogenous economic downturn would have meant that turnover would have decreased to an extent, regardless of the efficiency wage. Finally, Roff and Summers calculate that the productivity gains from such a wage increase were between 40-70%.
In conclusion we have seen that firms do have an incentive to pay an efficiency wage, in order to reduce shirking and increase productivity, and to reduce labour turnover costs. Evidence by Roff and Summers of Henry Ford’s efficiency wage supports this conclusion.