Efficiency Wage Theory

Basic idea

In the classical labor market model, unemployment pushes wages down until the market clears. In reality, firms often do not cut wages even when unemployed workers would accept less. Efficiency wage theory explains this by the effect of wages on productivity. Harvey Leibenstein (1957) argued that in developing countries higher wages improve nutrition and thus work capacity, and Robert Solow (1979) showed that if effort depends on the wage, a firm sets the wage where a 1 percent raise increases effort by 1 percent, the Solow condition. That wage minimizes labor cost per efficiency unit and can exceed the market-clearing wage. Yellen (1984) and Akerlof and Yellen (1986) synthesized this literature.

Four models

First is Shapiro and Stiglitz's (1984) shirking model. Because firms cannot perfectly monitor effort, they pay high wages so that being caught and fired is costly. When all firms do so, unemployment results, and unemployment becomes a "worker discipline device" that raises the cost of dismissal, an application of moral hazard and the principal–agent problem. Second, Salop's (1979) turnover model holds that higher wages cut quits and so save hiring and training costs. Third, Weiss's (1980) adverse selection model holds that higher wages attract abler applicants. Fourth, Akerlof's (1982) gift exchange model holds that when firms give the gift of above-norm wages, workers reciprocate with more effort; Akerlof and Yellen (1990) developed the fair wage–effort hypothesis, in which workers withdraw effort when paid less than they consider fair. Experiments by Fehr et al. (1993) provided evidence that such reciprocity prevents markets from clearing.

Evidence and macro implications

The classic case is Henry Ford's 1914 increase of daily pay from about $2.34 to $5. Raff and Summers (1987) found that turnover and absenteeism then fell sharply and productivity rose, consistent with efficiency wages. Krueger and Summers (1988) explained inter-industry wage differentials, in which workers of similar ability are paid systematically differently by industry, through efficiency wages. At the macro level, efficiency wages account for real wage rigidity and involuntary unemployment, with wages not falling even when labor supply exceeds demand, and became a key microfoundation of New Keynesian economics. They also explain why the natural rate of unemployment is positive. Critics note that firms could use performance bonds or seniority-based pay instead of high wages (Katz, 1986), and that direct measurement of effort is empirically difficult.

FAQ

What is efficiency wage theory in simple terms?

A company that deliberately pays more than the going rate gets workers who try harder, quit less and are better qualified, so the higher wage pays for itself.

Why do efficiency wages cause unemployment?

If all firms pay above market-clearing wages, more people want jobs than there are jobs, but cutting wages would lower productivity, so firms keep wages high and involuntary unemployment remains.

Sources reviewed: 2026-10-26

References

1. Shapiro, C., & Stiglitz, J. E. (1984). Equilibrium unemployment as a worker discipline device. American Economic Review, 74(3), 433–444.
2. Akerlof, G. A. (1982). Labor contracts as partial gift exchange. Quarterly Journal of Economics, 97(4), 543–569.
3. Akerlof, G. A., & Yellen, J. L. (Eds.). (1986). Efficiency Wage Models of the Labor Market. Cambridge: Cambridge University Press.
4. Akerlof, G. A., & Yellen, J. L. (1990). The fair wage–effort hypothesis and unemployment. Quarterly Journal of Economics, 105(2), 255–283.
5. Solow, R. M. (1979). Another possible source of wage stickiness. Journal of Macroeconomics, 1(1), 79–82.
6. Leibenstein, H. (1957). Economic Backwardness and Economic Growth. New York: Wiley.
7. Salop, S. C. (1979). A model of the natural rate of unemployment. American Economic Review, 69(1), 117–125.
8. Weiss, A. (1980). Job queues and layoffs in labor markets with flexible wages. Journal of Political Economy, 88(3), 526–538.
9. Raff, D. M. G., & Summers, L. H. (1987). Did Henry Ford pay efficiency wages? Journal of Labor Economics, 5(4), S57–S86.
10. Krueger, A. B., & Summers, L. H. (1988). Efficiency wages and the inter-industry wage structure. Econometrica, 56(2), 259–293.
11. Katz, L. F. (1986). Efficiency wage theories: A partial evaluation. NBER Macroeconomics Annual, 1, 235–276.
12. Fehr, E., Kirchsteiger, G., & Riedl, A. (1993). Does fairness prevent market clearing? An experimental investigation. Quarterly Journal of Economics, 108(2), 437–459.
13. Yellen, J. L. (1984). Efficiency wage models of unemployment. American Economic Review, 74(2), 200–205.