The False Prophets of Efficiency Wages

One of the least-convincing tropes of financial journalism is the article explaining how business firms can increase profits and at the same time engage in some conventional, culturally-approved, do-good activity such as improving the environment, saving energy, or helping the poor. The latest version is how to increase profits by increasing wages.

Here is James Surowiecki writing in the New Yorker:

A substantial body of research suggests that it can make sense to pay above-market wages—economists call them “efficiency wages.” If you pay people better, they are more likely to stay, which saves money; job turnover was costing Aetna a hundred and twenty million dollars a year. Better-paid employees tend to work harder, too. The most famous example in business history is Henry Ford’s decision, in 1914, to start paying his workers the then handsome sum of five dollars a day. Working on the Model T assembly line was an unpleasant job. Workers had been quitting in huge numbers or simply not showing up for work. Once Ford started paying better, job turnover and absenteeism plummeted, and productivity and profits rose.

Walter Frick writing in the Harvard Business Review agrees:

The theory of efficiency wages…suggests that firms sometimes have an incentive to pay workers more than the going rate because doing so attracts better candidates, motivates them to work harder, and encourages them to stay at the company longer.

(Similar kinds of stories are offered by Justin Wolfers and Jan Zilinksy and also Paul Krugman).

There are two problems with this story, one obvious and one not-so obvious. The not so-obvious problem is that the economists who developed the theory of efficiency wages (including Shapiro and Stiglitz, Akerlof and Yellen and Yellen) had no illusions that they were helping business firms to discover a new way to increase profits. The economists who developed efficiency wage theory were trying to explain persistent unemployment. Hence the title of Janet Yellen’s famous survey, Efficiency Wage Models of Unemployment.

The question that motivated efficiency wage theory was not why firms should raise wages but why firms don’t cut wages when they should. The answer they gave was that firms don’t cut wages despite unemployment because they fear that workers will respond to lower wages with reduced productivity. Thus, here is Akerlof and Yellen explaining that when workers demand “fair” wages they create unemployment.

…according to the fair wage-effort hypothesis, workers proportionately withdraw effort as their actual wage falls short of their fair wage. Such behavior causes unemployment…

In the original efficiency wage literature there is no wishful thinking–no idea that we can have more of everything that we want without tradeoffs. Instead of being desirable, the efficiency wage is a problem because lower wages would reduce unemployment and be better for the economy as a whole.

Instead of letting us bask in wishful thinking the real efficiency wage theory suggests unpleasant tradeoffs. Yellen, for example, suggests that if it were cheap, greater monitoring of workers would lower unemployment as would allowing workers to take low-pay or no-pay internships for trial periods. In our paper on asymmetric information, Tyler and I make such unpleasant tradeoffs clear:

When employers do not easily observe workers, for example, employers may pay workers unusually high wages, generating a rent. Workers will then work at high levels despite infrequent employer observation, to maintain their future rents (Shapiro and Stiglitz 1984). But those higher wages involved a cost, namely that fewer workers were hired, and the hires that were made often were directed to people who were already known to the firm. Better monitoring of workers will mean that employers will hire more people and furthermore they may be more willing to take chances on risky outsiders, rather than those applicants who come with impeccable pedigree. If the outsider does not work out and produce at an acceptable level, it is easy enough to figure this out and fire them later on.

Notice that the efficiency wage theorists took it for granted that to the extent that firms can increase profits by raising wages they have already done so (hence the persistent unemployment). Firms don’t typically leave $100 bills lying on the ground so the Stiglitz, Akerlof, Yellen assumption makes perfect sense. Thus the more obvious problem with the journalistic account of efficiency wages is that it makes it sound as if the idea that productivity might increase with wages is a revelation that firms have never considered. (See Frick for some implausible stories of why firms might not raise wages even when it is profitable to do so.) In fact, firms routinely track turnover and productivity and they are well aware that higher wages are a possible means to reduce turnover and increase productivity although, as it turns out, not necessarily the most effective means. Indeed, the whole field of workforce science deals with retention, turnover and job satisfaction and the relationship of these to productivity and it does so with more nuance than do most economists. Thus, it’s simply not plausible that large numbers of firms on the existing margin can increase wages, profits and productivity. TANSTAAFL.

In summary, the real theory of efficiency wages is an important and useful theory of persistent unemployment–one that helped earn Stiglitz and Aklerof Nobel prizes and Yellen a plum government job–but the journalistic proponents of “efficiency wages” are false prophets peddling false profits.

Comments

Tabarrok, as one would expect, focuses on the micro when it's the macro that determines prophets and profits.

Sorry, but I fail to see why this couldn't work both ways.

If Yellen et al propose that reducing wages could lead to reduced efficiency, it should stand to reason that increasing wages ought to have the opposite effect.

The question, then, as it always does, becomes finding the best balance between these opposing effects. I understand that many firms (which, collectively, constitute the all knowing market) will have given this good consideration, leading us to believe that the market wages are, at present, ideally distributed.

But in this ever-changing world, we can at least consider the possibility that our old models are off, and higher wages might now be a smart economic decision.

"If Yellen et al propose that reducing wages could lead to reduced efficiency, it should stand to reason that increasing wages ought to have the opposite effect."

No, it doesn't. It would be surprising if firms did not set wages at some local maxima - they'd be stupid if they didn't. You should expect profit to fall off with a change in either direction. It's obvious why profit falls off with a wage increase. The thing that needed explaining is why it also falls off with a wage decrease.

It's quite possible that firms aren't operating at their local maxima for stupid reasons.

This is different from saying that it's probable. Be very vary of any pundit who says "if all my opponents switched to doing the things I always said they should be doing, they would be doing much better."

The biggest objection is the one HBS had above:

firms sometimes have an incentive to pay workers more than the going rate because doing so attracts better candidates

You disemploy some people whose labor is worth $10/hour and employ some people who labor is worth $14/hour. This makes things worse for the worker whose labor is worth $10/hour.

> It’s quite possible that firms aren’t operating at their local maxima for stupid reasons.

Indeed. If you take the perfect-rationality assumption too seriously, you'll end up with the absurd conclusion that offering suggestions or advice to anyone in any circumstance is always useless because if your advice is actually welfare-improving people would already be following it. I think we could benefit from more general-purpose-rationality research on when to detect when other people (or, likely much more frequently, organizations) are actually following suboptimal strategies and when it's just the case that they know something you don't.

Okay fine, guys, but it would be astounding if everyone was acting incorrectly but just on the raising-wages side, which is what Will is suggesting. The reasonable thing to expect is that profit falls off in both directions. I agree that this is only true most of the time, for most firms, on average, etc, and that there might be a little error here and there.

That doesn't change the point that Will is catastrophically wrong in his intuition.

"If Yellen et al propose that reducing wages could lead to reduced efficiency"

That's not even close. They're saying reducing wages could lead to reduced unemployment, and this known as efficiency wages. Big difference. You can't just throw the words together without knowing what they mean.

But firms can't/don't reduce wages because they fear reduced productivity, so, yes, exactly what Will said.

@Urstoff Costco also employs far fewer people as it is a 'warehouse' store rather than retail.
It needs people to run towmotors, not stock shelves.

Meant for below.

As with many theories, once you 'control for all other variables' - in other words, create a totally artificial set of circumstances - the theory comes into shape. Out in the real word, will higher wages result in higher profits? It depends...
But at the same time, it's foolish to attack higher wages for forcing unemployment. If minimum wage employees only had to be paid $4 an hour, Manhattan real estate won't be any cheaper. There won't be more good restaurants, just a few more fast food joints - which are not needed anywhere. As far as government policy goes, support of a strong and broad middle class is the goal (although policy poo-bahs wince when told that middle class should try to encompass from about 30% to 80% of the wage distribution, since that means they are generally out of the middle class, which Americans don't like to think...)

Then why do firms increase wages? Wal-mart did it a few months ago while Costco pays higher than minimum wage.

In the case of Wal-Mart, probably in a bid to improve its public image.

I don't think it was just that. I think Wal-Mart has been having issues in its stores with quality of staff, empty shelves, etc. (Empty shelves is simply bad news for a retailer.) We tried to but Chicken Noodle Soup. Sold out.

Yes, firms can benefit from raising wages, but Alex's point is that by and large this is already priced into the market. Firms are already paying the wages that they think generate the optimal result in terms of productivity for their money.

The claim that there is lots of room for wage increases while also boosting profits depends on companies being ignorant of the effect of wages on productivity or systematically wrong about the optimal wage level. The former is clearly just dumb. The latter is possible, but can only really be taken seriously if one has a strong argument about the mechanism that is keeping wages artificially low. Why should we believe pundits' claims about the most efficient wage level, as opposed to those who have billions of dollars at stake? We should not, unless some impressive evidence is provided.

Then how do wages ever increase?

Um...really?

The market price of labor is the product of millions of individual decisions. Individual actors raise wages, lower wages, hire and fire, etc. for various specific reasons. The wages at an individual employer can go up for any number of reasons.

The market price of labor is a measurement of its value right now. That doesn't mean it will be worth the same amount a year from now. Conditions change, causing wages to go up or down. But the assertion here is that labor is priced wrongly right now. There is no obvious reason we should believe that is the case.

I think that Collin and Pshrnk have a significant criticism of efficient markets theory. Markets only become efficient, or nearly efficient through feedback effects. These are driven by people looking for opportunities to beat the market. One example is wages increasing because employers do think that they can benefit from the mechanisms Surowieki talks about.

Depending on how you define "feedback", I don't think any economists would claim otherwise. They know that employers don't have a literal productivity-meter that they watch and set wages accordingly each week. What most people seem to miss about economic theories, including most types of efficient markets theories, is that they are concerned about the aggregate, but within the aggregate there is immense complexity and variance. In general, wages of various markets reflect productivity and supply in demand; there's a reason that computer programmers are paid more than Wal-Mart workers, and it's not the benevolence tech firms. At the level of the individual, however, you'll find tons of variance, crazy reasons for paying certain wages, etc.

@Daniel, that makes sense, though I don't think "wages will never increase" as the supposed corollary of Alex's argument is worth much.

However, viewing this particular discussion through this lens, the claims about raising wages amount to "We just discovered a huge, unexploited way to beat the market!" and I think it is clear how one ought to respond to such claims.

Yes, it is market that set wages and I tend to think Wal-Mart is reacting to the market with latest increase. However, the unemployment rate is still over 5% so there are still people out there without work so what was the reason Wal-Mart raised wages?

I would believe it is a (relatively) high cost of replacing a trained employee who has very flexible hours which fits into some of the efficiency wages literature. So Wal-Mart had to something to keep some hold on their workforce to run efficiently.

Walmart is planning to automate checkouts, so they need fewer workers, but with the skills to maintain the auto-checkout. Slightly higher skill level, and probably want less turnover because the auto-checkouts are sufficiently specialized to Walmart's stores that they would have to train new employees.

"The former is clearly just dumb."

Yeah, we all know how smart and efficient corporate America is. http://en.wikipedia.org/wiki/Diseconomies_of_scale

That only helps Alex's argument. When firms like Wal-Mart see that they can increase profits with higher wages, they do so all on their own, meaning it's highly unlikely that you'll ever see wages are below their efficiency rate IN GENERAL.

Costco also employs much more skilled (or competent) individuals than Wal-Mart. Just go to a Costco and then a Wal-Mart and look at the type of people both employ. They're not paid the same because they're different types of workers. This may not have been in your mind, but people who argue that Wal-Mart is evil because Costco pays their employees so much seem to miss this point. If Wal-Mart paid higher wages, they'd be employing different people. Those super low-skill workers wouldn't still be working at Wal-Mart but with higher wages. They'd be unemployed or working at some other very low wage job.

They increase wages because in boom times with low unemployment, job growth is happening faster than the expansion in the supply of workers - so there's an incentive for individual firms to raise wages and lure away employees from their rivals.

I do think the popular conception of the "efficiency wage" has some value. If you pay significantly higher than your competitors, then odds are you will have some benefits from that - better retention, more selectiveness in hiring, etc. Of course, that comes with a trade-off in terms of higher labor costs, and it's not a coincidence that Costco is organized around minimizing labor costs (and costs elsewhere, hence why they only take one kind of credit card).

Wal-mart is at the Henry Ford point - too many workers leaving, and dancing too close to the edge of minimum wage payments has led to more class-action lawsuits for underpaying.

Henry Ford doubled wages in 1914 to forestall unionization.

Hollywood is heavily unionized and high paying, and yet it's globally dominant, year after year crushing movies from lower wage countries at the box office.

If he doubled wages to forestall unuionization, then it probanly decreased rather than increased his profits. And pointing out a sector that already pays high wages only strengthens Alex's point.

What exactly was Alex's point? I'm still confused. Is Alex saying that firms are axiomatically at the pareto optimal point of the wage-profit tradeoff? Why is that self evident? Is that a corporate version of the efficient market hypothesis? i.e. If the firms could be more profitable by raising wages they would already have? That sounds iffy.

Or is the point that raising wages does not *always* make sense? Of course. It'd be stupid for anyone to argue otherwise.

Do we have analysts speaking to a board or do we have writers speaking to the public? Either they are correct and altruistic, since they apparently gave away billions of dollars worth of advice, or they are full of shit, selling their politics and boosting readership.

Seriously, quit throwing Ford's name out there in this context.

He raised wages ONCE in his life. Other than that single moment [of what he probably viewed as weakness in every other moment of his life], he was arguably the single worst company owner working against labor throughout his entire career.

Look it up: Ford is synonymous with hiring thugs to beat workers.

Would we unionize horses and cows? Seriously in an Average-is-Over world we need to stop thinking of people with sub 130 IQs as fully human, its only standing in the way of pro-growth policies.

I've become worried about this. On some other websites, lefties basically assume that anyone who is unemployed, on welfare, etc. must be a complete drooling imbecile and thus cannot find any work. They do make them sound like animals who must be tended.

Nah, the $5/day wage came well before the massive unionization drives in the auto industry in the 1930s. He did it because his turnover was insanely high - think 100+% every year. And as others pointed out, he didn't raise it again until forced, so a good wage in 1914 became a bad wage by the 1920s and 1930s.

"Indeed, the whole field of workforce science deals with retention, turnover and job satisfaction and the relationship of these to productivity and it does so with more nuance than do most economists."

Indeed, there are numerous fields where the business people involved are, unsurprisingly, more sophisticated theorists than economists, yet economists seldom ask their opinions.

Indeed, there are numerous fields where the business people involved are, unsurprisingly, more sophisticated theorists than economists, yet economists seldom ask their opinions.

And your understanding of the comparative 'sophistication' of economic theory came from where?

i think you are paying him too much of a compliment what he is referring too is Henry Ford's The International Jew.

Ok, so a tentative explanation for the existence of sticky wages becomes ...what, exactly? That productivity only can be downwardly affected by pecuniary renumeration? If you believe that, I have a bridge over the Oresound to sell you. Actually, firms leave $100 bills on the ground all the time - this is basically the standard reason for restructuring firms. The mechanism for finding the $100 bills is also pointed out in the examples you refer to: reducing hiring costs, more productive workers.

Yeah, color me skeptical. My understanding of the positive effect of raises is that they are generally short-lived. I'd expect the same to be true of the effect of wage cuts, so I'm not confident in this as an explanation of sticky wages. Nobel prizes aside.

Actually, firms leave $100 bills on the ground all the time – this is basically the standard reason for restructuring firms.

Yes, that's exactly the point. Firms restructure all the time, and in the process adjust wages, all without minimum wages laws to tell them what to do.

Am I wrong, or is the point of the original that journalists don't always emphasize the whole picture ("In addition to increasing productivity/profits, increasing wages may also lead to increased unemployment") when reporting on economics?

Many journalists report data that support their personal views, and ignore the rest. Someone who titles his blog "Conscience of a Liberal" signals that he is writing not as a scientist nor as a journalist, but as a moralist.

I prefer to think that Krugman writes as a dumbass

And you call yourself 'just another' MR commentator! Don't be so modest. To the contrary I find you particularly thoughtful. More proof conservatives always have to immediately descend to name calling.Nothing proves how smart you are better than snark.

With all due respect to Tabarrok, Krugman is actually considerably more highly regarded among economists.

Krugman is not an economist, at least, not anymore. He's a political hack who writes fiction these days. You could drive a truck through the logic gaps in his prose. Only a "progressive" can take him seriously.

It seems plausible that for a given position there is an "optimal" wage in a given market that will generate the most profits, and that some employers may currently have staff who are being paid a wage below that "optimal" value. If the firm raised its wage to the optimal value and replaced its current staff with the more productive staff the higher wage would allow it to hire then it would maximize profits.

Of course the flip side is also true. A firm's current staff at a given position may actually be paid more than the optimal wage. In that case the firm would maximize profits by replacing its staff with cheaper (less productive) alternatives.

It seems like the default strategy for most firms is the "cheap" one: offer the lowest possible wage is able to attract applicants who can at least plausibly perform the basic requirements of the job. Any lower and the firm could only attract applicants that are "obviously" unacceptable.

I could see a firm with this strategy potentially benefiting from offering a higher wage. But not if it just gave raises to its current staff. The goal would be to replace the current staff with a more productive (albeit higher paid) set of employees.

The default strategy in any business is to make the tasks of workers as simple as possible so simple, unskilled, low-paid people can do them. This is where technology comes in.

This is false. Paying people more means you are more likely to retain them, which means you can benefit from the costs of developing their firm-specific skills.

Bravo, Alex. This needed to be said and you said it beautifully. I would add one more journalistic trope on efficiency wages that has always bothered me. This is the crude Keynesian argument that paying workers higher wages creates a market for the product they make. It is alleged that Henry Ford realized that only well-paid workers could afford his Model T's , so paying his own workers more created enough extra demand for his cars to pay for itself. Simple arithmetic disposes of this argument quickly. Even Henry Ford's employees were only a small fraction of the population. There is no way that the extra wage income of those employees is going to create enough demand to pay for itself, or even be noticed in the demand for Model T's. .

'There is no way that the extra wage income of those employees is going to create enough demand to pay for itself, or even be noticed in the demand for Model T’s.'

So, let's use Mercedes as an example. As noted in 'The Machine That Changed the World,' a certain German luxury car maker models are used almost universally in Germany as taxis - the reason being that mass production requires mass purchasing. Which is also why Mercedes (and all other major car makers in Germany) offer their workers the chance to purchase Jahreswagen - that is, a car sold at cost/discount, that they are required to keep for one year.

One might think that the number of German employees buying Mercedes compared to the total markiet is small - and one would be wrong.

Henry Ford gained the efficiencies of mass production by ensuring mass production - and whether it is due to paying workers more, offering cars as taxis, or selling cars essentially at cost to employees, mass production is pretty much the best way to reduce unit cost - thus ensuring higher sales. A fact well recognized by a car maker not noted for mass production - but still requiring mass production to remain competitive.

The fact that German auto industry workers are well paid is not precisely a coincidence - but then, Fiat now owns Chrysler, after Daimler cut its losses, rid itself of a considerably more poorly paid workforce.

Yes, why didn't Daimler think of just paying them more and then selling them Chryslers?

The discussion isn't about whether an individual firm here and there could increase profits by raising wages. At any given time, some firms will be paying too little, but by the same token, some firms will be paying too much. The discussion is about whether firms IN GENERAL could be paying too little. If you believe that's the case, you need a reason why this widespread inefficiency would exist.

"One might think that the number of German employees buying Mercedes compared to the total markiet is small – and one would be wrong."

Mercedes sold 1.5 million cars last year and had 129,000 employees. Maybe every single employee buys a new Mercedes every single year? That would amount to a whopping 8.6% of all sales.

And yet Chrysler is now synonymous with luxury and quality so looks like the high wage strategy is a loser

@prior_approval

But there's a difference between selling your product at cost to your employees, and giving your employees a raise. In the case of Mercedes, selling cars at cost to their employees doesn't hurt them (car manufacturers want to put more product out there, at the very least each car will generate more revenue through future demand for parts). Giving the employees an unnecessary raise would obviously hurt them, by increasing costs. By unnecessary I mean a raise that costs more than the benefits of better retention/higher productivity, which at some point are marginally 0, as a function of the wage. The market probably already operates at the optimal wage point.

So Ford made an error in paying high wages?

Obviously, the extra demand from Ford workers for Ford cars couldn't pay for itself.

But that's not what the post is about: the extra productivity from paying Ford workers more could pay for itself. Alex just believes that all profitable opportunities have already been taken advantage of, which basically means that management strategy has no effect.

So Ford's policy had no effect for good or for ill? Then why oppose the efficiency wage argument if companies raising wages won''t have any ill effect?

One area I still see the efficiency wage argument being relevant is the public sector. As you explain, in the market when an efficiency wage is optimal it's probably already been enacted. But in the public sector, the low levels of competition and the high potential for abuse and rent seeking makes paying somewhat above market wages sensible, as part of a "bribe against bribes".

If you can actually fire civil servants. We can't do that in America, so their pay should be below market rates.

Examples: VA staff, DEA agents in Colombia, ATF employees.

Pay for higher-end civil servants is largely below market rates.

Very unlikely. Considering that public sector employment is quite highly sought after (and the higher the end, the more so), the pay is probably significantly above market rates. Of course, the pay is only a fraction of what they get: very stable employment, less work, less stress, fewer hours, more holidays, will probably take more "sick" days (nobody cares), prestige (they "serve", not profiteer), good benefits including health care and a pension often unachievable anymore in the private sector for similar contributions etc.

There's no market per se in the public sector, the employer (the state) doesn't care much about costs (since it doesn't have to persuade the customers, it just forces them) or the performance of the employees (no feedback loop). On top, the employees are usually strongly unionized, so it's easy to see why they're paid more than they're worth.

Citation? The last article I read showed the median government position payed 50-58% above the private equivalent counting health and pensions.

I don't have an actual citation, but I've noticed, in the Bay Area, that local governments generally pay better than private sector salaries up to about $125k, but less well for more highly-paid jobs, like lawyers, physicians, senior engineers, managers of large departments, etc.. (With the cash value of purchased benefits included, the breakpoint is probably closer to $150k.)

However, there are some benefits to public sector jobs which don't have a direct cash cost - primarily job security - which many people are willing to trade off against cash compensation. So government agencies are able to attract reasonably good employees for highly-compensated jobs, even when the compensation they offer isn't as large as at private employers.

They also imply that all firms can / should do this. But then the higher wage is just the market wage, no? I suppose as unemployment increases around the dwindling number of employed, though, that would be also be a motivator for them to work hard.

It all comes down to what your money will buy. If your costs are low and the productivity of a new worker is not much less than someone who has been there for a while increasing wages will simply add costs. Unless there is a shortage of low wage workers, or the selection is too tattooed and pierced for your clientele to ensure, a higher wage offering will bring in a different group of workers where's the higher costs have some benefit.

Retention of skilled staff, long term institutional knowledge, very high training costs, low supply of the specific skills or aptitudes means higher wages.

An interesting point about new workers. If the initial costs are high, if turnover costs are high new workers face limited opportunities.

Seems like an odd semantic problem. If everyone is paying "above-market wages" because that increases productivity and employee retention, doesn't that wage just become the market wage? Are proponents of efficiency wages (like Surowiecki et al.) saying anything more than "wages track productivity"? Because that's been pretty standard economic theory for a long time now.

It isn't so much that firms don't leave $100 bills on the ground. It's more that the reason they haven't picked them up yet is unrelated to particular political narratives or something like giving all the money to the CEO. At any given time they are doing their best to identify $100 bills to be picked up and they are not going to walk over them because haha poor people or something.

The joke is someone asserting that systemically all low wage labor everywhere is undervalued by employers in general.

Great summary. I hate TANSTAAFL because it obscures more than it reveals. This is a much more accurate explanation.

Three observations:

1. It’s even worse than Alex says. An important first generation paper was Gintis and Ishikawa (1987), which had circulated in manuscript for several years previously. In it, efficiency wages were a source of employer power over workers, the basis for workplace authoritarianism.

2. Both modern labor relations theory and strategic human resource management recognize two clusters of policies which firms can adopt. One competes on cost, makes few investments in worker skill, pays close to reservation wages, and accepts higher turnover, etc. The other competes more on quality or incremental innovation, invests in human capital, pays more and relies to a greater extent on worker commitment. There is some opportunity for firms to choose between them, although the choice is also conditioned by market factors as well as the external institutional environment.

3. In a paper I wrote a long time ago (1990 I think), I argued that efficiency wages were characteristic of lesser-paid jobs with relatively explicit and upper-bounded performance outcomes, while bonded compensation (withholding a portion of compensation until some future date) was characteristic of higher-level jobs, where performance outcomes were less constrained. The main form of bonding was, I suggested, internal labor markets with expectations of future promotion.

I find it interesting that Alex starts out by referring to above average wages as "rents".
You really do not have to read any further to find out what he thinks.

Tell me, Alex, is an above average wage for a CEO "rent".

Wait - I thought workers were always paid at the marginal productivity of their labor?

There's always a tension between equilibrium price theory and the fact that mechanisms used to get to equilibrium pricing have to have something to work on.

You would be wrong. Workers are paid a wage which is their market value before they start working, which is a completely different value than what they produce. Their product is then taken and sold for the value added by the worker. The difference between wages and the price of the product is the employer profit.

Profit is a lot less than the difference between the price of the product and the employees' wages...

It's good to see someone still sticking up for the labour theory of value.

TANSTAAFL seems to have two meanings: one true and the other false. The true meaning is that scarcity is everywhere: we can't have unlimited amounts of all good things. The false meaning is that we are always already at the efficiency frontier: all the twenty dollar bills have already been picked up.

This post relies entirely on the false meaning, which is only ever approximately true, and then only in efficient markets with lots of parties bidding away arbitrage opportunities.

Since American employers do not have infinite foresight and information, it is possible that some of them could improve profitability by raising wages.

I don't see who would be in a better position to know what wages would be most profitable than the employers themselves.

Employers (to the extent they are faithful agents of shareholders) have an incentive to know what is profitable for their firms, but that doesn't prove that they do know. The assumption that employers/managers know best is just faith.

How is it an assumption or faith? All Hazel said is that firms are in the best position to know what is profitable for them rather than a 3rd party who has zero incentive to be right. There are firms paying above optimal and there are firms below optimal I'm sure, but to say that most are below optimal and can get something for nothing is what seems to be based in faith to me.

TANSTAAFL means that when something appears to be free, it's actually being paid for by somebody, usually somebody you can't immediately see.

The idea that all $20 bills have been picked up is the EMH, efficient market hypothesis, not TANSTAAFL.

The idea that goods are scarce is even more basic and profound than the EMH or TANSTAAFL.

Or maybe its that you're talking about nothing, other than doing your implicit job of backing your reasoning into whatever justifies the Koch's interests under the guise of market economics? How's that for a straussian reading of Cowen?

No references to black helicopters or the new world order - I give this a C

Quid pro quo corruption is sooo last century. Things are different now!

So Wallmart-of all companies, which isn't famous for liking high wages-as well as other companies that recently-within the last few years since the President called for a higher minimum wage-like Costco, et. al-are all just anomalies?

I forgot to mention that among the companies to recently raise wages even the boss who warned his employees not to vote for Obama now has given out raises.

let them eat beans

--queen tyler

"The theory of efficiency wages…suggests that firms sometimes have an incentive to pay workers more than the going rate because doing so attracts better candidates, motivates them to work harder, and encourages them to stay at the company longer."

30 years ago, my Labor Econ prof at Chicago argued for approaching CEO pay on this basis. Just look at the size of that brass ring! Now get back to work.

It sounded like malarkey then...

I'd like to see this type of analysis of employer provided benefits. The exact flow may be different but I suspect the end result of lower employment (or employment of people who do nothing but find ways around direct hiring) is among the unseen results.

We pay people to be productive. You you pay higher wages, you expect a higher return. What did Ford do with prices after raising wages?

I think this blog post is much more annoying than enlightening.

The most annoying part. The use of the acronym TANSTAAFL.

There are situations in which that acronym do not apply. Namely in situations which productivity increases, meaning you get more of everything.

The theory of efficiency wages MUST be true at some extreme. Imagine if you an employer paid someone so little such that they could not even afford enough food to maintain alertness. Is it possible that paying them more so that they can feed themselves would more than pay for itself? I think the answer is obvious.

In that case, TANSTAAFL would not apply. In fact, paying more would simply be an unambiguously good decision.

I think one mistake that economists sometimes make is failing to recognize that just because most decisions involve tradeoffs thinking that all decisions do. The decision to not jump off a three story building does not involve any major trade-offs. My decision not to do so shifts my production possibility curve outward.

There are stupid things that we are all doing right now out of ignorance that lower our productivity. It is possible that, in some situations, paying your employees less is actually simply a stupid move, and that paying them more could shift the production possibilities curve outward. We shouldn't assume that all cases where TANSTAAFL does not apply are blatantly obvious.

The simple economic argument as to why some firm increases wages is that there would otherwise be a shortage of labor. The firm would not be able to find enough employees.

The standard economic argument as to why wages have increased over the last couple of centuries is that the demand for labor has grown faster than supply so that if wages did not increase, there would be growing shortages of labor.

In other words, if wages averaged at $1 an hour today, as they did some decades ago, there would be a massive shortage of labor.

But what about the unemployment rate? If unemployment is greater than zero isn't there a surplus of labor?

No. The quantity of labor demanded is the amount of labor firms want to hire and the quantity supplied is how much people want to work.

The quantity of labor demanded is closer to employment plus vacancies.

The quantity of labor supplied is closer to the labor force (employed plus unemployed.)

If all labor and jobs were identical, then it would be hard to explain why there would ever be vacancies matched by unemployed workers.

But labor and jobs are not identical.

The unemployment rate is the amount of people who are currently looking for work. A shortage of labor would seem to imply that vacancies would be greater than the unemployed.

Anyway, I think the efficiency wage argument fails--it would be much more sensible to start workers are low pay for a probationary period and then give them raises after a time.

The assumption of the argument is that all workers earn the same wage, and so if you are fired, you can immediately get a new job at the same pay.

But if there is a probationary period at low pay, if you are fired, you have to start over at low pay somewhere else.

But that doesn't mean both that starting pay and the post-probationary pay won't increase due to changes in supply and demand.

Also, at least the simple version of efficiency wages assumes all workers are identical and so get the same wage in competitive equilibrium.

Obviously, wages are not anything like perfectly flexible, but I don't think efficiency wages explain why.

Also, the morale argument against cutting wages isn't the same thing as the efficiency wage argument.

It is interesting that Alex insists that you can never have more of everything despite the fact that I'm sure he would agree that cooperation through voluntary trade is mutually beneficial - Pareto improving, even!
It's not too hard to imagine a cooperative game in which higher wages and higher profits can be mutually achieved. Think about transactions costs and firms as organizations!

It's plausible that any given firm can get better results by paying its workers more; what's not plausible is that most firms could all do so at the same time. There are only so many workers available who are substantially more productive than average at any given job. While a specific firm might be able to selectively hire the above-average workers by offering above-average pay, not all workers are above average, so not all firms can make this work.

There is another way in which it might directly benefit a firm to raise wages even when it's not using higher wages to attract the most-productive employees, and that is in reducing employee turnover costs. But that's not an "efficiency wage" issue.

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