Efficiency of Highly Paid Labour - Research Paper Example

Highly paid labour is generally efficient and therefore is not dear labour Table of Contents Introduction Modern economic thought was formulated about 300 years ago or so. Many theories have been developed since that time but until only recently extensive investigations regarding the positive effects of high wages were generally confined to the recipients. The broader positive effects of higher rates of pay experienced by employers and the general economy that were addressed by Adam Smith in 1776 and Alfred Marshall a century ago have seen a higher degree of scrutinisation and study during the past two decades. Many prominent economists theorize that highly paid workers are usually more effective. By paying a higher wage than what is necessary according to a particular market standard is indeed a sound investment for a business rather than a baseless expense. According to Marshall, “highly paid labour is generally efficient and therefore not dear labour” (Marshall, 1890). The merits of increased payment as an incentive to employees are matters of debate. Other factors such as job satisfaction and opportunities for growth are also part of the equation, but the overwhelming modern bodies of work have clearly demonstrated that higher wages equal increased production. According to Smith, “Where wages are high, we shall always find the workmen more active, diligent, and expeditious, than where they are low” (Smith, 1776). This discussion will examine the plausibility of this statement including both the positive and negative aspects of higher wages. Rationalisation for Higher Wages The rationalisation of higher wage disbursements can be categorized within three main topics. The first two, adverse selection and sociological (fair-wage) are fairly straightforward and only require relatively little further explanation. The shirking model is somewhat more complex and will be discussed at greater length. Adverse selection simply maintains that by offering higher wages inherently increases the quality of the average job applicant thereby raising the quality of the average employee hired by the company. The sociological aspect asserts that higher wages builds a stronger allegiance to the company among employees therefore increasing worker production. In addition, this greater feeling of alliance causes reduced turnover rates which lower recruitment and training costs. The shirking explanation is that higher wages reduce idleness and the numbers of instances that job assignments are completed ineffectively by raising the level of personal detriment that losing that job would cause (Akerlof & Yellen, 1986). Efficiency Wage Theory An explanation of the term ‘efficiency wage’ is significant in this discussion. It defines the subject and encompasses all aspects of higher wage payments and how this strategy ultimately benefits businesses. The efficiency wage theory relates to wage-earnings established within a company that are higher than corresponding market wages so as to provide motivational commitment incentives and maintain an overall higher sustained effort from employees. According to efficiency wage theory “the setting of a wage above the market wage may under certain conditions enhance labour productivity and efficiency” (Shapiro & Stiglitz, 1984). The efficiency wage theory also forecasts that companies may exchange higher wages for expensive monitoring techniques. The fundamental principle of the efficiency wage theory is that it is ultimately more advantageous for businesses to pay salaries that are above the prevailing amount for labour providing this move produces an adequately larger gain in overall productivity. In other words, this involves determining if the front-end investment in higher wages to employees will increase the bottom-line because of the perceived positive outcomes. The efficiency theory provides an accepted rationalization for the reason that businesses pay wages that are above the prevailing market standard and therefore are considered a valid explanation for an assortment of outcomes related to the labour market. The more that employees are paid in the short-term, to a point, the more they produce which pays dividends in the long-term. The precise nature regarding the correlation between employee productivity efficiency wages depends on the specific variation of the efficiency wage model that is considered. Explanation of other Methodologies Of the three main methodologies, two, the sociological hypothesis and shirking model, incorporate the concept of worker effort into the equation. According to the latter, if businesses are faced with high supervision and monitoring expenses, wage payments above the standard labour market level are used to persuade employees against shirking their duties. “Where monitoring and supervision costs are low, firms will opt to pay lower wages but will have to undertake more intensive supervision to ensure that workers supply effort” (Shapiro & Stiglitz, 1984). The sociological or ‘fair wage’ hypotheses is established on the idea of loyalty, commitment and fairness. Employers are perceived by the staff that they are not simply concerned about paying a competitive wage rate but are paying wages that are of higher relevancy to other businesses of a similar description. The hypothesis stipulates that if the employees’ wage fails to meet or exceed what they deem as fair, the loyalty and therefore commitment level will deteriorate thereby decreasing their degree of performance (Akerlof & Yellen, 1990). The adverse selection conception is that businesses that pay higher wages are able to hire better quality employment applicants. Consequently, this offers an enhanced approach to hiring and the prospect of increased profitability for businesses that cannot afford to directly scrutinize the quality of employees’ work. In addition, employee turnover is curtailed which greatly reduces costs to employers. If an employee perceives that they are being paid more than they would likely receive if they were performing a similar task at another company, the likelihood of them resigning is greatly diminished. In the context of wage efficiency, the shirking model is likely the most popular explanation given by businesses for utilizing the concept. The central line of reasoning is that most employees have a predisposition to shirk and that because many organisations are so complex, the ability to monitor the performance of its employees is hardly cost-effective. In circumstances such as this, businesses are able to monitor employees on a random basis only. Therefore, they are forced to rely on paying employees at a suitable level so as to raise the anxiety of being dismissed. This, in turn, elicits greater effort and lowers the instances of shirking when not being directly watched. Employees know that they can be quickly replaced because of the higher prevailing wage being paid by the employer which heightens the fear that they will be dismissed if caught shirking. This perceived loss of employment and the loss of better-than-average wage is a powerful incentive not to shirk one’s responsibility. This is a concept employers know very well because it has proven itself not only in theoretical economic studies but consistently in the real-world scenario of the business world. Of course, variables to the concept apply such as the current amount of unemployment benefits compared to their wage and the transferability of their particular skill. “An increase in the relative wage or in stricter monitoring and supervision will therefore raise worker performance. Given the costs associated with monitoring, firms can achieve a given level of effort by paying a higher relative wage or by undertaking more direct monitoring” (Shapiro & Stiglitz, 1984). Effects of Employer Monitoring Increased employer monitoring does not lead to increased effort. Therefore, businesses will only decrease productivity with intense monitoring techniques rather than increasing productivity through efficiency wage strategies. Monitoring only serves to reduce the trust level that is potentially present between employer and employee. Workers that perceive the company does not trust them will inevitably lessen their efforts on the job. It’s simple human nature to do so. Another concept that centers on employee effort puts forward that relative earnings impact performance. This affects employees’ perceptions regarding fair treatment being received from their employer. “Higher relative wages increase commitment and loyalty to the firm and enhance motivation, encouraging more work effort. Lower relative wages, on the other hand, foster a feeling of being unfairly treated, are de-motivating, and lead workers to supply less effort” (Frey, 1993). Numerous studies have integrated unemployment and relative wage variables into business-level production equations so as to test the effect of efficiency wages. As an example, the use of business-level statistics conclude that employee productivity is usually greater, somewhat surprisingly, when the level of unemployment decreases or, not as surprisingly, when wages relative to other like-businesses increase. It should be noted that these outcomes are consistent with the shirking approach (Wadhwani & Wall, 1991). “Both relative wages and unemployment are found to raise productivity and are again broadly supportive of the shirking variant of efficiency wages” (Huang et al, 1998). Discussion of Studies Involved The preponderance of current studies conclude that elevated relative wages in a business reduces its occurrences of employee discharges related to incidences of shirking. The frequency of sacking for this reason is also lower in a particular labour market as those costs for unemployment benefits are relatively high. These tests for efficiency wages are conducted by surveying businesses that employ wage-setting procedures. Generally speaking, the questions are prepared so as to ascertain why businesses don’t reduce wages in the course of economic declines. Though these studies’ conclusions are not 100 percent reliable, which possibly reflects the discrepancy involved in industrial as opposed to national reporting, many general findings become apparent. A principal reason for avoiding a reduction of wages is the potential harmful impact this would incur on the overall motivation and morale of employees in addition to the perceptions of employer fairness, all of which would significantly influence their efforts on the job (Cambell & Kamlani, 1997). In businesses’ answers to survey questions which recount their strategies of wage-setting with regard to the amount of employee effort generated, there exists only partial substantiation for the shirking theory. Generally speaking, the view of employers is that incidences of shirking are not commonplace at their firm and shirking is seldom the reason that employees are sacked. Additionally, neither unemployment levels nor monitoring by supervisors are thought of as significant in the reduction of shirking in the workplace. Furthermore, there exists strong belief by employers that the efficiency wage approach regarding the impact of wage cutback would significantly increase employee turnover particularly when contemplating the reaction of the company’s most productive employees. Another component to consider is the few studies that scrutinize the effects that relative wages have on workers when compared to the extent of employer monitoring. These studies must rely exclusively on the subjective notion of effort and are based on company documented instances of an individual’s effectiveness (Goldsmith et al, 2000). The degree to which effort can be measured, the effectiveness, intensity level of work and the commitment of an employee is indeed a subjective area of study. In general, these studies provide broad confirmation for the efficiency wage theory which suggest that higher wages increases effort. However, they also indicate that relative wages carry more weight with employees than do differentials within the workplace. “Whilst higher wages increase effort, notions of fairness or equity are not important in workers’ decisions to supply more effort, thus casting doubt on the fair-wage hypotheses” (Levine, 1991). Employee Loyalty and Commitment Loyalty and commitment in the workplace have been shown to not necessarily go hand-in-hand. There is significant evidence that shows union members are less committed to their company yet shirk their assignments less than do employees that are non-union. Unionised workers are absent from the job to a greater extent than their non-union counterparts probably because they have more of a stronger sense of job security but this employment security does not affect their attitude regarding shirking. This is in contrast to common perceptions as well as the efficiency wage theory which predicts that a greater sense of job security would reduce the risks of employment loss in the mind of the worker and therefore increase the incidences of shirking. Expectedly, workers who do not have permanent employment contracts do not possess similar levels of loyalty to their employer than those that do. Seemingly, it is because employees have no permanent contract work harder because they perceive a lesser degree of job security which leads to an enhanced concern regarding the loss of their job due to shirking. Labour productivity is elevated in businesses whose employees have higher relative wages. In general, higher wages are shown to have a positive effect on workers’ degree of effort. These statements have been found to be true and consistent with both the fair wage and shirking approaches to the efficiency wage theory. “We find strong effects operating through loyalty and commitment – a central feature of the fair wage explanations for efficiency wages. Moreover, there are some anomalies in the findings that do not sit comfortably in the shirking framework, in particular the role of supervision, the threat of job loss and the difficulty with which firms can fill vacancies” (Leigh, 1981). Comparison of Wage Effects Even as comparisons between relative occupational and industry relative wages can be considered somewhat internal in nature, these proportions also incorporate external comparisons, those outside the business. Only those variables representing higher wages as a percentage of employees at the same business can be considered a purely internal comparison. It would seem that during each instance of wage comparison, the empirical findings defining employee effort are a more reliable measure of employee effort and are consistent with the fair wage theory. With regard to the effect that effort has on wages, there is a definite connection between wages paid and effort exerted. High levels of effort directly correspond to employees receiving higher wages. There is also a positive relationship between the level of labour productivity and wages as well as the reverse, a consistent relationship between wages and labour productivity. Relative wages, in summation, impact a workers’ level of effort, which consequently influences the businesses’ level of labour productivity. A practical study conducted last year by economists Uri Gneezy and John List reprove these assertions. They invited individuals to work in charity related occupations such as door-to-door collections and data entry positions but paid a portion of these employees a surprisingly high salary. They only worked for minimum wage. The higher paid employees worked very hard but the others didn’t last past noon on the first day (“Dear Economist”, 2006). Rebuttal of the Efficiency Wage Theory While evidence has clearly shown and the vast majority of economic theorists agree that higher wages increase productivity and are therefore a good investment for employers, a minority suggest that no such connection can be substantiated by empirical evidence. It is possible, they postulate, for revenues to increase because the prices of the businesses’ product has risen though labour productivity remain unchanged. Even if the average production output of workers has risen significantly supposedly as a result of wage increases, if the product prices or profit margin declines because of the wage increase, the revenue return per employee possibly would have either remained constant or declined. Those that theorize an association between wages and labour productivity within either an occupation or industry unconditionally presuppose that when employee production rises, their contribution to the businesses’ revenue increases which causes the demand for the employee’s services to increase as well. This scenario is not necessarily justification to increase wages accordingly. The assumption is incorrect because wages are driven by the principle of supply and demand. The efficiency wage theory is flawed for two reasons. First, there are not necessarily any connections between revenue per-employee and output per employee. As was explained previously, if the demand for a businesses’ product decreases, the price that is charged for the product decreases as well. Thus, even if employee production increases, the revenue gained per employee most probably will decrease. Moreover, when production output per-employee increases, the business must sell more of their product thereby causing the supply to increase. However, by utilising the principle of supply and demand, if the supply of a product increases, its price decreases. That is, the increase in worker productivity may cause a decrease in prices. In certain instances, this decrease in a product’s price is so extreme that an increase in worker productivity may actually cause a decrease in revenue per worker. The best example of such an occurrence is in the agricultural industry where farming incomes have been subject to a continual descent though productivity has experienced an upward trend. Additionally, even if labour productivity increases and leads to an escalation in returns produced per employee, the subsequent increase in product demand is not necessarily associated with a long term wage increase within that particular industry. The reasoning is that, in the long term, additional employees can be added to the industry. This acts to compensate any pressure on the prevailing wage rate to increase. “When demand for an industry’s workers increases, wages in that industry do not rise relative to wages in other industries. Rather, it is employment in the high productivity industry that will rise relative to employment in other industries” (Bruce, 2002). For example, it is assumed that there are a large segment of construction workers such as electricians, plumbers and carpenters who received approximately a similar rate of pay. If a housing boom occurred, there might be more of an increase in demand for carpenters than either plumbers or electricians. Because it takes more carpenters to build a house than plumbers or electricians, the total numbers of carpenters needed to fulfill this boom could thus be proportionately larger. The point is, in the short term, it would be impossible to train a sufficient number of carpenters to supply the current, short term need and consequently, wages would increase among this segment of construction worker. However, when carpenter’s wages are higher than electricians or plumbers, incoming workers to the construction industry will choose to train as carpenters. Before too long, the number of carpenters will increase while the number of electricians or plumbers will decrease. When the housing boom is over, there will be an over supply of carpenters and their wages will decrease while the wages paid for electricians and plumbers will increase. In due course, the wages will equalize among all three of these construction professions. All will earn higher wages at some point in the cyclical process but the increased wages of plumbers and electricians will have taken place without an increase in their productivity. The increase was determined by the prevailing market conditions. In addition, the carpenters’ wage increase would have been proportionately less than their increase of productivity because the effects of the increase would have been weakened by the increased entry of employees from the other two construction categories. Furthermore, if the original number of carpenters were substantially less than the quantity of electricians and plumbers, it is probable that any increase in wages reaped by the three classifications of worker would have, at best, been very minor. In such a described scenario, the number of electricians and plumbers that would have been forced to abandon their trades would be negligible compared to that trade’s overall workforce. The effects on wages, on the whole, would not be felt on that occupation simply because of their departure during this short term market fluctuation. The efficiency wage principal has little to do with an increase of productivity. Market influences and the law of supply and demand is the driving force for either wage increases or decreases within an occupation or industry (Bruce, 2002). Similar market influences are observed in all industries. The food service segment is a classic example. In recent years, the ‘fast food’ industry has experienced a much greater rate of productivity gain than have restaurants that serve ‘four star’ cuisine. However, the wage increase of the former is actually lower in relation to the latter. The fundamental reasoning the increased demand for ‘fast food’ employees has more than been matched by an amount of unskilled workers that are available to fill these positions. This does not imply that there exists no correlation between wages and productivity at an industry level. If the level of an available workforce within a particular industry has remained unresponsive to wage fluctuations, a productivity increase could bring about a lasting increase in wages. For example, “there may be institutional barriers preventing additional workers from entering an industry such as union regulations or restrictions on the numbers of students training for that industry at university or college” (Bruce, 2002). In addition, a gain in productivity on a nationwide level is not as probable to reduce product prices as a comparable productivity gain at the industry level. When the production increases at a business, it may be necessary to reduce prices and possibly its workforce as well but when production increases on a national level, the incomes of the entire workforce for that industry will increase. The increased production is generated by an increased demand to purchase that product and prices do not necessarily fall. If prices fall, the ‘real’ income of all workers increases. All workers will gain financially not because wage increases boosted production but that the nation-wide increase of production lowered the average cost of products to consumers. There are unassailable theoretical rationales for expecting that there is almost no connection between an industry’s growth in productivity and growth of wages. The practical evidence provided is persuasive and makes it incumbent for economic theorists to further justify their argument that a connection is present between wages and productivity (Bruce, 2002). High Wages and Unemployment A problematic situation that arises as a result of high wages is that unemployment rises accordingly. When the price of labour increases in the form of wages, the amount of labour required decreases because the cost to run a business is unchanged. To stay in business, the business must reduce its workforce. Put another way, if wages are increased, a greater amount of people will be seeking employment but employers will not be in a position to hire additional labour. The result is a surplus of labour, in other words, higher rates of unemployment. If wages decline, the surplus of labour declines and unemployment numbers fall. Theoretically, if the wage rate is truly equalised, both the quantity of labour and products that are required are equal and therefore little unemployment occurs. For a balance to be achieved in a fluctuating market, wages should be adjustable as well. The principle cause for inflexible labour market wage rates is that trade unions have bargaining power with employers. Therefore it is expected that national economies where a greater percentage of its workforce is unionised, the higher the wage rate will be thus the higher unemployment rates occur. This contention is supported by comparing American and European experiences. In Europe, the percentage of union workers has either risen or remained stable for the past half century and unemployment increased. By contrast, U.S. unemployment figures have decreased mainly because of the decrease in union membership numbers (Lane, 1995). Conclusion Essentially, the efficiency wage theory is based on the concept that businesses find it a worthwhile investment to pay wages above the average for that industry so as to draw the interest of a higher quality employee and to retain those more productive workers in their organisation. Higher wage rates have been shown to cause a higher rate of unemployment and the efficiency wage theory does have its skeptics who point to ‘real world’ applications in an attempt to debunk the theory. From a humanistic as well as a business perspective, however, it is generally wise for employers to pay wages that allow employees to live in conditions other than impoverished. References Akerlof, G.A. & Yellen, J.L. (1986). Efficiency Wage Models of the Labor Market. G.A. Akerlof & J.L. Yellen (Eds.). Cambridge: Cambridge University Press. Akerlof, G and Yellen, J. (1990) “The fair wage-effort hypothesis and unemployment.” Quarterly Journal of Economics. Vol. 105, pp. 255-283. Bruce, Christopher. (Summer/Autumn, 2002). “The Connection between Labour Productivity and Wages.” Economica Ltd. The Expert Witness Newsletter. Vol. 7, No. 2. Campbell, C.M. and Kamlani, K.S. (1997). “The reasons for wage rigidity: Evidence from a survey of firms.” Quarterly Journal of Economics. Vol. 107, pp. 205-251. “Dear Economist.” (15 April, 2006). Financial Times. Available 2 February 2007 from Frey, B. (1993). “Shirking or work morale? The impact of regulating.” European Economic Review. 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