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Study Notes

Efficiency Wages

AS, A-Level, IB
AQA, Edexcel, OCR, IB, Eduqas, WJEC

Last updated 3 Apr 2021

This study resource looks at an important concept in labour market economics - efficiency wages.

Efficiency wages - a short video explanation

What do we mean by efficiency wages?

This is a theory that suggests it may benefit businesses to pay workers a wage higher than the prevailing market equilibrium wage rate. The benefit of doing this might be (over time) an increase in the value of labour productivity for the employer.

Justifications for paying efficiency wages

  1. Paying a higher wage improves worker morale which can then have a positive impact on productivity (measured perhaps by output per hour worked)
  2. Paying higher wages can lead to a higher quality of people applying for new jobs as they become available. Firms can then screen and select from a better pool of available people.
  3. Offering a better wage reduces absenteeism in the workplace – people stand to lose more if they are absent from work
  4. It can also lead to a reduction in labour turnover which saves businesses the costs of re-hiring and training new employees

Key impacts might focus on worker effort, motivation, recruitment, retention, and ultimately on firm profits.

Topics where the idea of efficiency wages might be used:

  • Assessing the economic impact of a rise in the national minimum wage on variables such as cost-inflation and corporate profits
  • Challenging whether firms with monopsony power in the labour market will pay lower wages – a growing number of firms are now living wage employers
  • Principal-agent problem – how higher wages might be a response to the problems and costs of directly observing & measuring labour productivity

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