The Minimum Wage is Really an Efficiency Wage

March 20, 2014
By Oren M. Levin-Waldman, Ph.D.

Market Purists are steadfast in their belief that increasing the minimum wage will lead to lower employment. The standard textbook model holds that as workers lower their wage demands, employers will demand more of their services.


A wage floor only prevents workers from accepting lower wages in exchange for opportunities to work. Therefore, fewer workers will be hired, with the result being lower employment. But opponents of minimum wage increases are only citing half of the model.

What the model really says is that a minimum wage if it is effective will do either one of two things: it will either result in the layoff of those workers whose value is less than the minimum or it will result in an increase in productivity among low-efficiency workers. Of course, one way to increase efficiency would be to substitute technology for low-skilled workers. But given that most low-skilled workers are concentrated in the fast-food and retail sectors, that option may have limitations. Another way to increase productivity is for employers to invest in the human capital of their workers by providing them with the type of training that will enable them to become more productive.

In other words, instead of thinking of the minimum wage as a social negative because of supposed employment effects, it is time to think of it more as the efficiency wage it could be intended to achieve greater productivity and prosperity. The idea of the minimum wage as an efficiency wage dates back to a famous essay by Sidney Webb in 1912, and is ironically recognized by the competitive market model.

Webb argued that better paid workers would be able to better maintain themselves, and because that meant they would be eating better they would come to work with more energy and naturally work more efficiently. But higher wages would also improve their morale, as they would feel better about the work they were doing. This would lead them to put more effort into their jobs. Employers too would see that their workers were working harder and would seek to invest more into their improvement in order to justify the higher wage. Consequently, overall efficiency would improve, thereby leading to increases in productivity.

The notion that a minimum wage improves efficiency is often referred to as the “Webb” effect. But it has found expression in the competitive market model, albeit in a slightly different, if not somewhat bizarre form. In a famous paper about 30 years ago, Nobel laureate Joseph Stiglitz — who more recently has been arguing about the dangers of rising income inequality — along with Carl Shapiro argued that the minimum wage can be an efficiency wage to the extent that employees earning higher wages will take steps to avoid shirking.  Employees who receive higher wages have a stronger incentive to hold onto their jobs because the costs associated with job loss. Moreover, employers also derive benefit because the costs of higher wages are offset by savings in monitoring costs.
Of course, the anti-shirking argument isn’t a whole lot different from the Webb effect. The former couches it in the standard economics language of incentives and disincentives, whereas the latter suggests that improved efficiency flows from improved morale. One is merely more easily quantified than the other. Still, the idea is the same.

Higher wages lead to greater efficiency for the simple reason that better paid workers not only have greater incentive to put more effort into their work, but they have less incentive to pick up and leave. In other words, employers who pay higher wages don’t have to lay off workers or necessarily raise prices in order to prevent the increase from eating into profits. They can save money from reduced turnover, which only decreases the costs of recruitment and retraining.
It would appear that amidst the national policy debate over whether to raise the minimum wage to $10.10 an hour as being pushed by Democrats in Congress and the President, some employers have come to recognize that there really is greater efficiency to be derived from higher wages. Consider that Cosco pays its workers an average of $20 an hour because it wants to keep its employees. The Gap recently announced that it would be raising its minimum wage to at least $9.00 an hour because it too doesn’t want to lose good employees. A spokesperson for the national chain actually said they were committed to investing in its workforce.

The American Consumer Satisfaction Index recently reported that those stores with the lowest levels of consumer satisfaction were also not surprisingly among those paying the lowest wages. That alone should be a warning. One gets what one pays for. Consumers dissatisfied with the service they are getting will naturally go elsewhere. Paying a higher wage, then, is not as some on the right would derisively label a “feel-good” measure, but in the end is about the bottom line.
We cannot continue to be a prosperous nation if we cling to the belief that efficiency is defined as greater output for less input, including labor costs. The market place is not simply a place to pursue our own selfish interests with total disregard for our neighbors. That is a gross misreading of Adam Smith. Rather, the market place is the way we achieve the most efficient organization of the greatest number of people for achieving a common purpose: prosperity. People forget that Smith was above all a moral philosopher.

It would be nice if more low-wage employers on their own could come to recognize the greater efficiency in higher wages. As most still cling to the first part of the competitive market model, wages need to be increased through policy. Were a minimum of $10.10 to be adopted and then indexed to either the inflation rate or productivity increases, all future increases could then be planned for because they would be anticipated. This then would be less of a shock to the system, which again would only improve efficiency. It is time to recognize the efficiency benefits of the minimum wage.


March 20, 2014

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