Efficiency Wage Theory: Pay For Performance And Performance Evaluation

Research Project Topic

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.

In the economic literature, the Efficiency Wage Theories focus exclusively on the relationship between pay and performance. The Efficiency Wage Theories maintain that firms should offer their employees a wage that is above the market clearing rate. Paying employees a wage premium raises productivity, workplace cohesiveness, employee responsibility and loyalty, and reduces shirking. Conversely, a wage that is below the prevailing market rate can contribute to employee dissatisfaction and other negative attitudes (e.g. outrage and a desire for revenge), and ultimately a high turnover.

You should aim to think critically and write originally.
A key component of the assessment of the assignment will be based on your ability to explain your answers using the economic concepts and theory discussed in this unit. You will be rewarded for linking the theory with a real life example.
• You are required to research this topic. Use the readings on Efficiency Wages (in LMS) to build up your essay.

Efficiency wage theory is an important section of Labor Economics. Alfred Marshall introduced the term “efficiency wages” or “efficiency earnings”, which refers to the wage per efficiency unit of labor. It deals with the idea that employers pay their employees a wage, which is higher than market clearing wage in order to increase their productivity or efficiency, and reduce costs of turnover as well as from higher production. It also helps to reduce the turnover costs in some industries where cost of replacing labor is quite high. The increased worker productivity and/or reduced costs help to pay for higher wages (Weiss 2014).

The logic behind efficiency wage theory is that, paying higher wages than the marginal revenue products of the labour ultimately benefits the firms. According to Daley (2012), higher wages to the workers result in the increased productivity as higher wages would motivate them to feel loyal about their employer and work harder. Higher wages also inflict insecurities among the workers. They fear about losing their jobs and hence, they work harder to keep their jobs at a wage, which is higher than the market clearing one. Thus, the companies get higher productivity from the workers even if they had to pay more. It also helps them to retain their workers, and thus, reduces their labor turnover costs.

According to Schmitt (2013), efficiency wage theory explains the unemployment and market failure. As workers get higher wages, there could be unemployment in the economy, and that could lead to market failure. To avoid this situation, sometimes the government intervenes with minimum wage policy. Although, efficiency wages do not always lead to unemployment, it could also lead to uncleared markets and job rationing. Sometimes there could be full employment in the economy as well as efficiency wage prevailing in some markets. In such cases, there would be excess supply of labor in those markets and some of the workforce might have to work at a lower wage (Haefke, Sonntag and Rens 2013).

 The literatures on efficiency wage reflects the idea that firms should pay their employees a wage, which is above the market-clearing wage. A higher wage has some positive effects on the employees such as, raising productivity, responsibility of the workers, workplace cohesiveness, sense of loyalty and devotion and reduction of shirking nature of the employees (Ehrenberg and Smith 2016). On the other hand, the wage, which is below the market wage rate, can cause worker dissatisfaction and create other negative impacts such as, outrage, strikes, non-cooperation. It also leads to more shirking or sabotage activities and finally, more turnover of the workers.

2.0 An efficiency wage perspective on wages and performance

The theories suggest that the reason of unemployed workers being unable to bid down the market wages can be explained with the help of effects of negative incentives of low wages. The principles of efficiency wage theory states that the wages of the workers affect their productivity positively. Hence, the firms find it advantageous to pay the workers a wage that is higher than the market clearing one. It is possible because the wage, which minimizes the cost of per efficiency unit of labor, might not be the market clearing wage. It might make the firms reluctant to reduce the wages even if there is excess supply of labor, because they fear that cutting down the wages can reduce the workers’ productivity more than proportionately and thereby raise the cost of labor. Thus, equilibrium can coexist with involuntary unemployment in some markets (Ryska and Prusa 2012).

The literatures on efficiency wage theory analyses various conceptually distinct but complementary ideas on direct relationship between efficiency and wages of workers. These literatures are based on the probable benefits of the firms, which pay higher wages, raise in the efforts and reduce in shirking by the employees, reduction in turnover costs, high quality of the labor force, improved self-esteem, easy teamwork and greater feelings of loyalty by the employees (Booth 2014).

Alternative reasons for the payment of non-competitive wages are related to the presence and influence of the unions and collective actions of the workers. Thus, in most cases the firms find it profitable to pay higher wages than the market rate to maintain peace in the organization. It is found, that the firms, which have no unions, tend to pay higher wages to avoid future unionization. This policy of higher wage also attracts more qualified labor from the market (Tomohara and Ohno 2013).

The theories on efficiency wage theories provide coherent explanation of natural unemployment. These also provide explanations for persistent ‘non-competitive’ wage differentials across the industry for the labor with similar productivity. According to the Marshallian Efficiency Wage theory, employers provide different wages to the employees having different level of efficiencies. However, the theories generally show that higher wages influence the productivity of the workers in a positive manner, through different channels, and that makes it worthy for the employers to spend more on the wages of the workers (Reisman 2013).

The effectiveness of pay for performance can be evaluated with the help of some studies and indicators in the market. The existence of such a strategy is not the only differentiator between high and low performing organizations. Regardless of the performance, every company has a pay for performance strategy. Although the annual increment in salary is considered as an entitlement and not a reward for performance of the employees (Jha et al. 2012).

2.1 Drivers for pay for performance strategy

The maximum number of high performing organizations reported that rewards and recognition of the employees with high productivity is the main driver for the pay for performance strategy. The second driver could be the increase in chances of accomplishing the organizational goals as well as personal benefits. If the performance of the organization is better, automatically the employees, who performed better and contributed in the company’s growth, would achieve benefits. This in turn would motive them to increase productivity and perform better in the future. Hence, it can be described as a cycle of pay and productivity (Georgiadis 2013).

Shirking model is assumed to be the best model to describe the efficiency wage. It assumes that the firms need efforts from the employees to manufacture goods and services; the efforts of the employees are imperfectly observable and the employees, who provide less than the contractual level of effort, would lose the job. If the employees have any incentive to shirk on the job and their job is difficult to observe, then internal or external monitoring is used. External monitoring helps the managers to oversee the efforts put by the employees, but this is a costly technique in many industries, where it is difficult to measure the efforts of the employees in terms of contribution towards output due to lack of proper technology and systems (Weiss 2014).

The issue of shirking can be best handled by using self or internal monitoring. The firms should have an internal monitoring policy to increase the responsibility awareness among the employees. The employees would self-monitor their efforts if the job is attractive or pays a relatively higher wage than the competitive and market clearing one. The higher wage is believed to raise the cost of shirking and reduce the incentives to shirk, because if an employee is caught shirking, the loss in terms of wage would be higher. Alternative employment might not pay higher wages and it would make the job less attractive, and employees might not feel motivated to give more effort. Hence, both the factors are interdependent. It is beneficial for the firms to pay higher wages to the employees to get more productivity from them; on the other hand, employees will also reduce shirking on the job if they get higher wages (Tomohara and Ohno 2013). 

The other significant models of efficiency wage are Turnover Cost model and Gift exchange models. Turnover cost model explains that by paying higher wages, firms can reduce exit rate and turnover costs, that is, the cost of selecting, recruiting and training the employees. It also helps the firm to achieve human resource development, which leads to increased productivity of the workers. Gift exchange model reflects the concept, that higher wages are a gift from the employers to the employees. It imposes a feeling of gratitude among the employees and they put forward more effort by themselves to achieve more productivity (Ehrenberg and Smith 2016).

2.2 Literatures on efficiency wage model

Higher wages always make a job more attractive compared to other jobs in the competitive market. Since, the quality of labor in the market is heterogeneous; firms often pay wages, which is above the market-clearing rate, to attract higher quality workers. The evaluation of their performances can be tracked in terms of efficiency and level of quality production (Shields et al. 2015).

Figure 1: Relationship between Relative Wage Rate and Worker Efficiency

(Source: Shields et al. 2015)

The above figure shows the relationship between the relative wage rate and efficiency of the workers. It reflects that efficiency of the workers rises faster than the real wage up to the point w*, and slowly after that. The cost of labor efficiency is maximum at w* in (b). Hence, w* is the efficiency wage and the firms do not have any incentive to reduce the wages as that would increase their wage cost per unit of output (Jenter and Kanaan 2015)

To evaluate the performance of the employees, a firm should follow the steps mentioned below (Brown and Reilly 2012):

• Setting strategic reward goals, such as, recruit, retain and motivate the employees, and deciding the criteria for the success of the organization. Then the firm should assess the performance of the employees that how much they contributed towards achieving the goals. The reward goals include fair and equal rewards, quality incentives, clarity and transparency, external market focus, personal choice and flexibility and so on.
• Reward reviews reflect the performance of the employees. Such reviews include detailed report of employee performance along with structure of competitive pay levels and bonus and incentive plans, which can motivate the workers to work harder.
• Assessment of the effect of planning and implementing changes of business procedures on the performance of the employees, such as, training and development programmes, improved communications among the workforce, more comforts in the workplace, changes in working hours etc (Charness et al. 2012).

In Australia, performance-based-pay schemes were introduced in Australian Public Service (APS) in 1998 and 1999 under the Workplace Relations Act 1996. After the introduction of the Act, the public sector of Australia has done experiments with individual performance pay system. The initial system was limited to only senior executive service and senior officers, but after 1996 Act, it was introduced for every employee of the public service sector (O'Donnel and O'Brien 2015).

APS has merit pay schemes, which links the individual effort and pay. Such schemes always encourage the employees to deliver better quality jobs. Goal-setting theory of efficiency wage reflects that merit pay helps to improve the employees’ performances when the goals are clearly defined, challenging and accepted by the workers. However, this merit pay scheme was not that effective to motivate the employees as expected due to the concerns regarding procedural fairness of the scheme. Many Australians believed that there was a quota on top of the rating scores and favoritism worked in the rating allocation by the supervisors, which led to internal issues among the employees (Frey, Homberg and Osterloh 2013).

The performance based pay also increased the gender biasness in the workplace as it reduced the transparency of the pay structure. As mostly male supervisors or managers assess the female employees, often the discrimination on sex, age, race play important role in the assessment and those can create biasness in the review and hamper the appraisal process (Taylor 2013).

In APS, the procedural concerns are too much for such incentive plans. Mostly the performance appraisals are subjective to the regulations as well as biased view of the supervisors. Hence, lower ratings can demotivate the workers to perform well. The budget limitation in the public sector also creates dissatisfaction among the employees. Sometimes one employee gets the benefit at the expense of the other.

It has also been found in Australia, that the public sector employees are more interested in the sense of achievement and accomplishment rather than in the payment of incentives. However, the private sector prefers the tangible rewards to the intangible rewards (O'Donnel and O'Brien 2015).

According to Sammer (2014), to fix the issues of efficiency wage, the employers can take the following measures:

• Develop a transparent tier based review process: any rewards and incentive programme of a company should be transparent and equal for all employees. It should consist of justified tiers for individual performance levels to qualify for incentives and rewards.
• The company should establish general bonus criteria at the beginning of the year. Both the employer and workers must have a mutual understanding of the company’s goals and objectives for the coming year. This way the company can track an employee’s activities and performance and decide on the right incentive payouts according to the performance.
• A firm should ensure that employees with a performance level below the threshold are not eligible to receive an incentive. This way there would be fairness in the system and the low performing employees would be motivated to perform better if they do not get incentives. The firm can reallocate that amount of fund to the high performers.
• The managers as well as the employees should be educated about the incentive plan system. Everyone in the organization should be aware of the objective and working of the system and they should act accordingly to get the most out of it.
• A firm should keep the incentive payout decisions subject to the higher level reviews and approval. Managers are held responsible for any unjustified incentive payout decision and this rule makes them very cautious about reviewing the employee performances (Lee and Saez 2012).

Conclusion:

When a firm applies the policy of effective pay for performances, it ensures that rewards are closely and clearly linked with performances of the employees. It also creates some obstacles along with a fair incentive plan. Although the firm encourages fairness, equality, rewards and recognition in the working environment, it also creates blocks to trust and encouragement. Hence, an organization should be very careful about the welfare of the employees while implementing such a bonus system. There are always mix of high and low performers in an organization. It should not ill-treat the poor performers; rather it should encourage those low performing employees by appreciating and motivating them towards the recognition and bonus schemes. They may not be entitled for the same rewards as the higher performers but they should also be given incentives for improving their performances. The author describes the features of efficiency wage theory in the context of effective pay for performance system in Australia. Like any other economic model, this wage system also has some pros and cons. Any organization should apply incentive payouts based on performance of the employees to achieve profit maximization. This system not only helps to increase the productivity of the workers, but it contributes in the growth of the company also. Hence, in Australia as well as other economies of the world should have efficiency wage programme.

References:

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

Brown, Duncan, and Peter Reilly. Measuring The Effectiveness Of Pay And Reward Practices. Ebook. 1st ed. Brighton: Institute for Employment Studies, (2012).

Charness, Gary, Ramón Cobo-Reyes, Natalia Jiménez, Juan A. Lacomba, and Francisco Lagos. "The hidden advantage of delegation: Pareto improvements in a gift exchange game." The American Economic Review 102, no. 5 (2012): 2358-2379.

Daley, Dennis M. "Strategic human resource management." Public Personnel Management (2012): 120-125.

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Georgiadis, Andreas. "Efficiency Wages and the Economic Effects of the Minimum Wage: Evidence from a Low?Wage Labour Market." Oxford Bulletin of Economics and Statistics 75, no. 6 (2013): 962-979.

Haefke, Christian, Marcus Sonntag, and Thijs Van Rens. "Wage rigidity and job creation." Journal of monetary economics 60, no. 8 (2013): 887-899.

Jenter, Dirk, and Fadi Kanaan. "CEO turnover and relative performance evaluation." The Journal of Finance 70, no. 5 (2015): 2155-2184.

Jha, Ashish K., Karen E. Joynt, E. John Orav, and Arnold M. Epstein. "The long-term effect of premier pay for performance on patient outcomes." New England Journal of Medicine 366, no. 17 (2012): 1606-1615.

Lee, David, and Emmanuel Saez. "Optimal minimum wage policy in competitive labor markets." Journal of Public Economics 96, no. 9 (2012): 739-749.

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Reisman, David. Alfred Marshall: Progress and Politics (Routledge Revivals). Routledge, 2013.

Ryska, Pavel, and Jan Prusa. "Efficiency Wages and Involuntary Unemployment Revisited." Quarterly Journal of Austrian Economics 15, no. 3 (2012): 277.

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Schmitt, John. "Why does the minimum wage have no discernible effect on employment." Center for Economic and Policy Research 22 (2013): 1-28.

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