Efficiency Of Pay For Performance: A Literature Review Essay.

You are hired by the Fair Work Commission Australia as a consultant to examine issues relating to pay and performance.  Your task is to provide a report detailing findings from the economic literature on the effectiveness of pay for performance, and how performance should be evaluated based on incentive pay.

Literature Review

The essay aims to analyze how efficiency of workers are related to higher wages. Wage refers to the return that workers receive in exchange of their work effort. It is the incentives for workers to work. In a free market, combined forces of demand and supply determine equilibrium wages. The equilibrium wage is considered efficient in determining full employment. However, wages are often paid above the equilibrium wage. An important theory that explains the rationale for offering wage beyond the equilibrium wage is the theory of efficiency wage (Weiss 2014). The theory of efficiency wage considers work effort as an important component in determining productivity of workers. Monitoring work efforts is costly. Therefore, incentives are provided to the workers in form of in form of higher wages above the equilibrium. The hypothesis of adverse selection suggests a correlation between reservation wage and productivity of workers. The hypothesis proposes that a higher wage attracts a better quality worker. These workers also receive internal incentives for performing well. In the model of shirking threat, external incentives are given to workers to increase work effort. There are other theories as well that support the efficiency wage theory such as turnover model, model for workers’ health and others. Equilibrium wage is often determined at such a low level that create dissatisfaction among workers. The dissatisfaction harms workers’ productivity and increases attrition in the workplace. There are however, theories that contradict the proposition of efficiency wage (Georgiadis 2013). The backward bending labor supply curve suggest that labor supply does not increase uniformly with increase in wages. Beyond a certain level of wage labor supply falls, as workers give priority to leisure time over work effort.

The body of this paper has been divided into three parts. In the first part, theoretical literatures are discussed by considering the past studies. In the second part, empirical test has been conducted to compare salaries of sales representatives of KFC and Mc Donald. The third part finally suggest how workers can be motivated with efficiency drawing reference from past literature.

Cyclical fluctuation and efficiency wage: The Keynesian economists suggests that business cycle fluctuations are characterized by existence of involuntary unemployment. It is however difficult to develop a business cycle model with involuntary unemployment because of difficulty in explaining non-clearance of labor market. Involuntarily unemployed people agree to work at a wage below the equilibrium (Ehrenberg and Smith 2016). Despite this, firms do not cut wage to increase profitability. The efficiency wage theories explain why firms find it unprofitable to cut wages during involuntary unemployment.

Studies found that the movement of work effort as described by efficiency wage is countercyclical. Work effort should be go up when unemployment increases. In terms of economic theory, firing a worker has a lower chance of getting another job during high unemployment. This makes unemployment more threatening. Proponents supporting this argument concluded that high unemployment is associated with a lower rate of turnover indicating less rehiring. There are however studies that have found the opposite arguments to be true. That is during high unemployment turnover tend to be higher as well. Work effort explaining the foundation of efficiency wage in found to be inversely related with unemployment created during business cycle fluctuation. There is a simple intuition behind this. The micro foundation theory of labor market suggests that workers in the primary labor market only fears to be monitored (Lavoie and Stockhammer 2013).  When the chance of keeping a job in primary labor market decreases because of high unemployment, less importance then is given to that fear. During this time, workers cannot be threatened for being monitored or fired as they already faced high risk of losing jobs.

Relation between efficiency wage and backward bending labor supply curve

Backward bending labor supply curve: The theory of backward bending labor supply curve bears great policy implication. The theory contradicts the traditional theory of upward sloping supply curve. The notion of upward sloping supply curve based on the assumption that substitution effect for a change in wage always dominates the income effect making the labor supply curve upward sloping. In real world, however income effect might dominate substitution effect making the labor supply curve to bend backward (Kool and Botvinick 2014). Many studies found in the absence of income effect, labor supply curve slopes downward.

The labor supply curve explains the association between available supply of labor and market wage. In general, the labor supply curve is assumed to be positively sloped. The positive association between wage and labor supply however does not hold always. Evidences from real world suggest that the labor supply curve is bending backward. This can be explained with income and substitution effect. As income increase, workers can afford more goods and services. This is the income effect of increased wage. Higher wage means a higher opportunity cost for leisure. Workers thus tend to substitute leisure with work hours (Brecher and Gross 2014). This is the substitution effect of increased wage. The ultimate impact on labor supply is subject to magnitude of income and substitution effect.

Figure 1: Income effect and substitution effect of wage change

(Source: Johnson 2017)

The vertical axis measures money income or wage. In the horizontal axis, both labor supply and work hours are measured. With initial wage of W_0, the money income line is given as M₀T. Equilibrium is attained at the point R. The work hours is equivalent to L₀T and leisure hours is given as OL₀. As wage increases, the money income line shifted to TM_1.  Corresponding to the new wage, the equilibrium point shifted to H. The new equilibrium is associated with a higher leisure hours of OL₁ and smaller work effort to L₁T. The substitution effect attempts to increase work effort from L₀T to L₂T. The income effect on the other hand attempts to lower the work hours L₂T to L₁T. As income effect is larger than substitution effect, the ultimate effect is lowering the work effort.

There are different explanation for offering a high wage to the workers. In context of less developed countries, the first explanation is in term of linkage between wage, nutrition and health of workers. For developed economies, arguments that are more appealing are given by shirking model, turnover model and adverse selection model.

The Shirking Model: In most of the jobs, workers have some discretion regarding performance. The employment contracts cannot rigidly cover all aspect of their job duty and responsibility. Monitoring every worker is a costly practice and often gives inaccurate result (Card et al. 2018). Under this circumstance, offering wage above the equilibrium wage might be an effective way to reduce shirking. The higher wage provides workers incentive to work instead to shirking.  

Turnover Model: High wage is often offered to reduce turnover rate in the firm. The argument of turnover model is same as that of shirking model. With relatively high wageworkers are more reluctant to leave the high paid job of the existing firm (Booth 2014). When all firms in the industry are identical, paying workers wage above the equilibrium with involuntary unemployment help to lower turnover rate.

Need for paying efficiency wage for workers

Adverse Selection Model: The model of adverse selection provides another explanation for the relation between wage and productivity of workers. A positive correlation between ability of workers and reservation wage implies higher wage helps to attract more abled workers. In this model, firms by offering an efficiency wage drives away applicants from firms offering a comparatively lower wage. Workers’ willingness to work for a wage below the market wage imposes an upper bound on workers’ ability indicating the worker is a lemon (Janet 1984). The adverse selection model to provide an efficient explanation for involuntary unemployment firms should be unable to observe work effort and pay piece rate after hiring workers or firing worker if output found to be low.

Labor market segmentation: The shirking model of efficiency wage provides rationale for existence of dual labor market. In a dual labor market, utility among similar workers differ across the jobs in primary and secondary labor market. The proposed hypothesis states that labor market can be categorized into two groups (Antonelli and Quatraro 2013). Primary labor market characterized by internal labor market and high wage and secondary labor market comprising of low paying jobs where there is little or no room for advancement. The main objection to the argument of segmented labor market is that if workers in secondary sector are envy of primary sector and they are as productive as primary then wages in secondary labor market should be lower to the level of equilibrium wage (Katz 1986). Empirical evidences suggest the high paid workers in the primary sector are show a high degree of responsibility and take independent action in part of the employee. Low paid job in the secondary market on the other hand are subject to supervision. The efficiency wage, which is above the equilibrium wage, creates difference in utility between jobs in primary and secondary labor market causing job loss costly in the primary sector (Alt and Iversen 2017).

The famous automobile company moved to a high wage to lower the turnover rate. Working in assembly lines is an awful job for most of the workers. This led to the problem of high turnover rate. High turnover is costly for any company. Company needs to train a new person for working in assembly lines and then engages that person to the line of work. During the learning process, the worker is generally slow compared to others. Henry Ford paid US $5 wage per day to reduce the turnover and speed up working in assembly line (Roy 2016). The $5 wage to the Ford workers is what economists called efficiency wage. Paying workers age more than the prevailing wage rate in the market for the same skill benefits a company in many ways. Workers consider the fact that losing current job would lead them to a lower paying job. The higher wage was not successful completely in reducing turn over. Turn over still remains a problem for the automobile manufacturers despite paying a high wage. This because some workers were simply unable to adjust with the monotonicity of doing work in assembly line. Therefore, they preferred to shift to the pay structure that offer them longevity. In addition, high compensation rate became a big problem as their workforce and market shrank (abc.net.au 2018). The higher cost deterred their competitiveness. Efficiency wage is a successful marketing strategy in a business model where competitors cannot follow the same.

The proposition that efficiency wage theory increases worker effort and motivation do not hold for public sector. There is one view that workers in public sectors are generally found to be less motivated following high wage. Studies found that workers are in public sectors are not driven much by monetary motives (Sharif 2018). Instead, intrinsic rewards like scope for helping other are more valuable to them. Even students who are willing to join public sector show less interest towards monetary rewards compared to those willing to join private sector jobs (Taylor and Taylor 2011). Past literatures found that the relation between payment to the workers and public sector motivation is insignificant. This implies monetary rewards do not have any influence on either to increase or decrease workers effort on workers’ performance in public sector. This however does not mean wages or monetary rewards are completely irrelevant to all the public sector employees. One study found that monetary benefits are important to many government sector employees.

This section compares the hourly wage rate for a sales representative working in KFC and McDonald in Australia. McDoanld and KFC are two of the most popular fast food centers in Australia. Both the centers pay a relatively higher wages to their workers to expand sales. The hourly wage rate for sales representative in KFC is $22.58 (Kfc.com.au 2018). Wage for the same post in Mc Donald is $19.32 (Mcdonalds.com.au 2018). At present, the minimum wage in Australia is $18.90 per hour (abc.net.au 2018). The workers in Mc Donald and KFC are already getting wages above the minimum wage. The Mc Donald’s wage in Australia is even higher than wages in many of the European nations. In France, the average wage rate roughly equals $12.00 per hour. The higher price and higher volume of sales allow them to offer wage above that in United States. In Australia, Big Mac is charged 6 to 70 percent excess from its price in United State. The higher wage in KFC and Mc Donald are also supported by rapid expansion of sales volume of both the centers in Australia.

Figure 2: Efficiency wage in KFC and Mc Donald

(Source: as created by Author)

The Collins Food in Australia that is the biggest KFC’s chain here has been recorded a revenue growth by 21.7 percent this year. The revenue has been expanded through rapid expansion of KFC’s business in Australia. Along with revenue growth, number of stores in Australia. The company is focusing on improving its performance in Australia through establishing further restaurants, operational management and profit margin (businessinsider.com.au 2018). The higher paying sales representatives help in business expansion by offering satisfactory service to the customers that promotes sales. The same is also true for Mc Donald. In 2016, Mc Donald recorded sales of $5 billion in Australia despite intense competition in the local market (Heffernan 2018). Mc Donald has experienced a steady growth in Australia in terms of both sales and guest count.

As far as the findings suggests, the theory of efficiency wage offers a convincing explanation for the relation between wage and work effort and workers’ efficiency. Paying a higher wage is an efficient way to reduce turnover, shirking behavior and attract better quality workers. A higher wage benefits both the employers and workers. Employers are benefitted from increased work effort and resulted profitability. The higher wage increases workers affordability to purchase more goods and services and hence, increase their standard of living. This provides rationale for paying a wage above the equilibrium level. In real world, also many firms adapt the strategy of efficiency wage (Cobb 2016). Henry Ford for example paid an efficiency wage to reduce workers’ turnover. The fast food centers Mc Donald and KFC in Australia offered wage above the set legal minimum wage. Both Mc Donald and KFC have experienced rapid growth in the past few year. Higher wage to sales representative contribute to improve customer service resulting in an increase in volume of sales and revenue.

In reference to theory and empirical evidences, wage can be used to motivate workers in the workplace. However, firms should also consider the concept of backward bending supply curve. The backward bending supply curve suggest that the proposition that labor supply increases with increase in work effort holds only up to a certain extent. It is true that with increase in wage, the opportunity cost of leisure increases and hence, workers substitute leisure with work hours. With increase in work effort productivity increases which is beneficial for the firm. However, beyond a certain level workers prefer to enjoy leisure hours. After this point, income effect dominates substitution effect resulting in a lower work effort with an associated higher wage (Kitagawa, Ohta and Teruyama 2018). Labor supply curve thus bends backward and firms no longer receive additional benefits by offering a higher wage. Firms thus should not raise wage to a very high level.

The efficiency wage theory also ineffective in situation when all the competing firms pay the same higher wage. Under such circumstance, higher wage only increases cost of the operating firm lowering their competitive power. While increasing wage firms should also consider the cost aspects as well. If increase in profitability is relatively lower compared to increase in wage cost then net effect of increasing wage is negative and thus does not have any effect on well-being of the firm.

Many studies found that monetary reward does not always work the primary motivational factor. Beyond wage, other factors can be used to motivate worker. For example, employers can allow some holidays to workers to enjoy their leisure times. This gives workers a break from their monotonous jobs and increases productivity. Other benefits should also be provided to in addition to direct salary. Such as medical facilities, travelling allowances and others. Several facilities along with wage give workers a feeling of security and hence, increases productivity.

In order to encourage workers to perform well, wage can be used as an efficient tool. However, following the theory of backward bending supply curve, wage should be set slightly above the market-clearing wage. Workers can also be provided other incentives to motivate them. The monetary and other incentives should be based on evaluation of performance and payment.

Conclusion

The essay analyzes relation between payment and performance in the workplace.  The theoretical and empirical literatures reviewed to critically evaluate the how wages are related to workers’ performance. Paying a wage above the market-clearing wage without any legislation is known as efficiency wage. In less developing nation, an obvious explanation for higher wage is to improve health condition, which can increase productivity of workers. In context of developed nations, the relevant models of efficiency wage include shirking model, turnover model and adverse selection model. The shirking model and turnover model suggest that offering high wage is an efficient way to reduce workers’ turnover and shirking tendency. High wage is also used as a tool of attracting a better quality of workers. Another explanation of efficiency wage is given by the theory of segmented labor market. The labor market segmentation states the dual market (primary and secondary) exists with differing payment structure and utility.

Henry Ford paid its workers efficiency wage to lower workers’ turnover. In Australia, KFC and Mc Donald also offer a wage to its sales representative above the legal minimum wage. Efficiency wage has found to be beneficial for these companies. A contradictory theory of efficiency wage is the theory of backward bending supply curve. Considering thus fact, it can be concluded that firms should not solely depend on wage as a tool for motivating workers. Rather other form of incentives should also be given to enhance performance of workers.

References

abc.net.au. 2018. "Higher Wages, Fewer Jobs? It's Not That Simple". ABC News. https://www.abc.net.au/news/2015-01-29/koukoulas-higher-wages,-fewer-jobs-its-not-that-simple/6052010.

abc.net.au. 2018. "Minimum Wage Earners To Get An Extra $24 A Week". ABC News. https://www.abc.net.au/news/2018-06-01/australian-minimum-wage-increased-by-3.5-per-cent/9824282.

Alt, James, and Torben Iversen. "Inequality, labor market segmentation, and preferences for redistribution." American Journal of Political Science 61, no. 1 (2017): 21-36.

Antonelli, Cristiano, and Francesco Quatraro. "Localized technological change and efficiency wages across European Regional Labour Markets." Regional Studies 47, no. 10 (2013): 1686-1700.

Booth, Alison L. "Wage determination and imperfect competition." Labour Economics 30 (2014): 53-58.

Brecher, Richard A., and Till Gross. "A minimum?wage model of unemployment and growth: The case of a backward?bending demand curve for labor." International Journal of Economic Theory (2014).

businessinsider.com.au. 2018. "Collins Foods, The Rise Of KFC And The Fall Of Sizzler". Business Insider Australia. https://www.businessinsider.com.au/collins-foods-full-year-results-kfc-sizzler-2018-6.

Card, David, Ana Rute Cardoso, Jörg Heining, and Patrick Kline. "Firms and labor market inequality: Evidence and some theory." Journal of Labor Economics 36, no. S1 (2018): S13-S70.

Cobb, J. Adam. "How firms shape income inequality: A rejoinder to Zardkoohi and Bierman." Academy of Management Review 41, no. 4 (2016): 749-754.

Ehrenberg, Ronald G., and Robert S. Smith. Modern labor economics: Theory and public policy. Routledge, 2016.

Georgiadis, Andreas. "Efficiency Wages and the Economic Effects of the Minimum Wage: Evidence from a Low?Wage Labour Market." Oxford Bulletin of Economics and Statistics75, no. 6 (2013): 962-979.

Heffernan, Madeleine. 2018. "Mcdonald's Australian Sales To Hit $5B". The Sydney Morning Herald. https://www.smh.com.au/business/companies/mcdonalds-australian-sales-to-hit-5bn-20161023-gs8i13.html.

Janet L. Yellen. “Efficiency Wage Models of Unemployment”. The American Economic Review 74, no. 2 (1984): 200-205

Johnson, Roger D. "The Supply of Labor." In Rediscovering Social Economics, pp. 105-120. Palgrave Macmillan, Cham, 2017.

Katz, Lawrence F. "Efficiency wage theories: A partial evaluation." NBER macroeconomics annual 1 (1986): 235-276.

Kfc.com.au. 2018. "KFC Australia | Home". Kfc.Com.Au. https://www.kfc.com.au/.

Kitagawa, Akiomi, Souichi Ohta, and Hiroshi Teruyama. "Ranking and Long-Term Unemployment in a Model with Efficiency Wages." In The Changing Japanese Labor Market, pp. 65-115. Springer, Singapore, 2018.

Kool, Wouter, and Matthew Botvinick. "A labor/leisure tradeoff in cognitive control." Journal of Experimental Psychology: General 143, no. 1 (2014): 131.

Lavoie, Marc, and Engelbert Stockhammer. "Wage-led growth: Concept, theories and policies." In Wage-led Growth, pp. 13-39. Palgrave Macmillan, London, 2013.

Mcdonalds.com.au. 2018. "Mcdonald's Australia". Mcdonalds.Com.Au. https://mcdonalds.com.au/.

Roy, Sucharita. "Efficiency Wage Models and Different Policy Implications." The International Journal of Business & Management 4, no. 1 (2016): 268.

Sharif, Mohammed. Work Behavior of the World's Poor: Theory, Evidence and Policy: Theory, Evidence and Policy. Routledge, 2018.

Taylor, Jeannette, and Ranald Taylor. "Working hard for more money or working hard to make a difference? Efficiency wages, public service motivation, and effort." Review of Public Personnel Administration 31, no. 1 (2011): 67-86.

Weiss, Andrew. Efficiency wages: Models of unemployment, layoffs, and wage dispersion. Vol. 1192. Princeton University Press, 2014.