Efficiency Wages: Paying Above the Market

Why some employers deliberately pay more than they need to, from Henry Ford's five-dollar day to modern firms, and what this means for unemployment.

Basic economics suggests firms pay the lowest wage needed to attract workers. But many firms pay more than the going rate. The theory of efficiency wages explains why this can be profitable.

Henry Ford’s five-dollar day

In 1914, Henry Ford shocked the business world by roughly doubling pay for many workers to five dollars a day. Ford’s assembly line work was repetitive and exhausting, and turnover was extremely high: workers quit constantly, and the company had to keep hiring and training.

After the pay rise, turnover and absenteeism fell sharply, and productivity rose. Studies by economists Daniel Raff and Lawrence Summers found the higher wages brought real benefits to the company.

Why paying more can pay off

Lower turnover: workers are less likely to quit, saving hiring and training costs.
Greater effort: workers who earn more than they could elsewhere work harder to avoid losing their job. Economists Carl Shapiro and Joseph Stiglitz modelled this in 1984.
Better applicants: higher wages attract more skilled workers.
Morale and fairness: workers who feel fairly treated reciprocate with effort, an idea developed by George Akerlof.
Nutrition: in very poor settings, higher wages allow better nutrition and health, raising productivity.

Implications for unemployment

If many firms pay above market-clearing wages, more people want jobs than there are jobs available. This helps explain involuntary unemployment: people willing to work at the going wage cannot find jobs.

Modern examples

Some retailers and tech firms pay above-market wages, citing lower turnover and better service.
Studies of minimum wage increases often find lower turnover among affected workers.

The warehouse decision

A warehouse pays the local average wage, but half its workers quit every year. It raises pay by 15 percent. Turnover falls sharply, experienced workers stay, errors decrease and training costs drop. Overall costs barely rise, while performance improves.

Thinking the cheapest workers are always the most profitable

Low wages can bring high turnover, low effort and poor quality. Paying more can sometimes lower total costs.

Key takeaways

Efficiency wages are wages set above the market rate to boost productivity.
Henry Ford's 1914 five-dollar day reduced turnover and raised productivity.
Higher pay can reduce quitting, raise effort and attract better workers.
Efficiency wages help explain involuntary unemployment.