Efficiency wages

A third theory that suggests that wages and profit are correlated is the payment of efficiency wages. Efficiency wages refer to wages paid above the market-clearing level of productivity in a competitive market (Shapiro & Stiglitz, 1984). If worker productivity depends positively on wages, firms may find it profitable to pay efficiency wages. In contrast to the rent and risk sharing theories, the causal relationship between wages and profit in the efficiency wage theory runs from higher wages to higher productivity and hence profit. Several conceptually distinct mechanisms have been put forward in the literature to explain the payment of efficiency wages.

92 Firm performance and workers’ wages: Evidence from microenterprises in Uganda

A first model of efficiency wages postulates that they are paid in order to minimize turnover costs (Salop, 1979). If firms must bear part of the costs of turnover and if turnover is a decreasing function of the wages firms pay, there may be an incentive to raise wages in order to minimize turnover costs (Krueger and Summers, 1988).

A second mechanism presumes that efficiency wages are paid to raise workers’ effort level under imperfect information (Shapiro & Stiglitz, 1984). In a competitive labour market, a rise in the real wage of workers will lower the aggregate demand for labour. This creates an unemployment pressure leading to a lowered incidence of shirking at the workplace. Therefore, without increasing internal monitoring costs or implementing punishments, firms can extract higher productivity from their workers. Workers being fired due to shirking will find it more difficult to regain employment than before the wages were raised, given the lower demand for workers under these circumstances. Wage dispersion for identical workers arises in both models because of firm-specific differences in the cost of turnover, the cost of monitoring and the cost of employee shirking.

A third theory is based on selection rather than incentive efforts. If workers are heterogeneous in ability and if ability and reservation wages are positively correlated, firms that offer higher wages will attract higher-quality job applicants (Katz, 1986).

Lastly, firms may pay efficiency wages to improve workers’ morale and loyalty to their firm (Akerlof, 1982). Improved morale and loyalty, in turn, may have a direct, positive effect on workers’ productivity. In Akerlof’s partial gift exchange model, the firm can succeed in raising group work norms and average effort by paying workers a gift of wages in excess of the reservation wage, in return for their gift of higher effort.

Solow (1979) shows in a simple model how increased wages directly affect productivity through an increase in worker effort. Assuming labour is the only production factor, identical, perfectly competitive firms aim at profit maximization:

𝜋 = 𝑌 − 𝑤𝐿 (15)

where 𝑌 is the firm’s output, 𝑤 the wage it pays and 𝐿 the amount of labour it hires. Firm’s output is not only a function of the number of workers, but also their effort.

𝑌 = 𝐹(𝑒𝐿), 𝐹^′(∙) > 0 𝐹^′′(∙) < 0 (16) Wage is the only determinant of effort.

𝑒 = 𝑒(𝑤), 𝑒^′(∙) > 0 (17) We assume there are 𝐿 identical workers. Every worker supplies one unit of labour inelastically.

The problem of the firm may then be rewritten as

Firm performance and workers’ wages: Evidence from microenterprises in Uganda 93

max𝐿,𝑤 𝐹(𝑒(𝑤)𝐿 − 𝑤𝐿 (18)

Unconstrained firms chose 𝐿 and 𝑤 according to the first-order conditions:

F^′(e(w)L)e(w) − w = 0 (19)

F^′(e(w)L)Le^′(w) − L = 0 (20) We can rewrite equation (19) as:

F^′(e(w)L) = w

e(w) (21)

Substituting equation (21) into equation (20), and dividing by 𝐿 yields:

𝑒^′(𝑤^∗)𝑤^∗

𝑒(𝑤^∗) = 1 (22)

The optimal wage 𝑤^∗ satisfies the condition that the elasticity of effort with respect to the wage is unity (Solow condition). The wage 𝑤^∗ is known as the efficiency wage since it minimizes wage costs per efficiency unit of labour. Because here 𝑒 (and thus 𝑒^′(𝑤^∗)) only depends on 𝑤, equation (22) implies that all firms pay the same wage. Inter-firm wage differentials exist if firms face different costs of turnover and supervision¹⁴.

The efficiency wage theories presented above are additive. Firms may pay non-competitive wages with the intention to reduce shirking and turnover, to attract a high-quality labour force and to increase workers’ feeling of loyalty. When looking at efficiency wages from the view of implicit contract theory, there is a trade-off between risk sharing and the payment of efficiency wages. Asymmetric information and moral hazard (and hence the offering of efficiency wages) set a limit to the use of labour contracts as a risk sharing instrument. A labour contract that fully (or even partly) insures the worker against risk may reduce the workers incentives to exert effort at work.

The more employees the firm has, the more difficult is it to monitor each of them. Hence, efficiency wages are expected to increase in firm size. Thus, the literature frequently uses firm size and the ratio of supervisor to employees as controls to test for efficiency wages. For instance, Oi and Idson (1999) find that the organization of work tasks and the selection of workers (whose productivity is not always observable) are responsible for the positive relation between wages and firm size.

Velenchik (1997) examines different explanations for the wage premium associated with working for larger firms in the Zimbabwean manufacturing sector. The results support the

14As can be shown in a more general model of efficiency wages, where supervision matters for workers’ effort (Fafchamps &

Söderbom, 2006).

94 Firm performance and workers’ wages: Evidence from microenterprises in Uganda

idea that larger firms may use higher wages to increase the quality of their applicant pools, to reduce employee turnover, and to enhance worker loyalty. Evidence for efficiency wages is also found by Arbache (2001), Esteves (2006) and Menezes and Raposo (2014) for the case of Brazil. Fafchamps and Söderbom (2006) conclude that larger firms in nine SSA countries and Morocco pay a wage premium to motivate their workers to exert effort and initiative.

Proposition 5: The positive effect of profit on wages significantly increases in firm size.