Efficiency Wage Theory & Impact on Labor Market

Efficiency Wage Theory & Impact on Labor Market
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  • 0:03 Efficiency Wage Theory
  • 0:52 The Market-Clearing Wage
  • 1:49 Why Use Efficiency…
  • 2:54 Effects on the Labor Market
  • 3:49 Lesson Summary
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Lesson Transcript
Instructor: Brianna Whiting
In this lesson, we'll discuss efficiency wage theory. We'll cover what it is, how it impacts the labor market, and why companies may turn to this type of practice.

Efficiency Wage Theory

Kip owns his own business making wood carvings. After being in business for only two years, Kip's company has become so popular that he has increased the number of employees from the five he started with to his current number of 35. The employees all have their own job duties, and all are important for the success of the company.

However, Kip has noticed lately that there has been a higher turnover rate than he has experienced before. Kip knows that he needs to find a way to retain his employees, but how? After doing some research, he comes across a concept in which companies pay their employees a higher wage to motivate them to work harder and stay with the company. This concept is known as efficiency wage theory. In this lesson, we will learn what it is, why it is used, and the effects it has on the labor market.

The Market-Clearing Wage

Before we learn more about efficiency wage theory, let's define a key concept. Market-clearing wage is a term used to indicate the wage at which the supply of labor equals the demand for labor. When supply and demand of labor balance, there is neither unemployment nor a shortage of labor. When employees are earning more than the market-clearing wage, their company is using efficiency wage theory.

Efficiency wage theory is the idea that paying employees more than the market-clearing wage will benefit the company. Under this theory, companies benefit from this ''overpayment'' by retaining employees and motivating them to work harder. When employees get paid more, they may begin to feel like an important asset to the company and, therefore, develop loyalty. Employees may also feel that because of higher pay, there is a greater chance of being terminated due to the company's higher labor costs. This is another incentive for the employee to work harder to keep his or her job.

Why Use Efficiency Wage Theory?

We know that companies want to keep their employees. Consequently, they often consider using efficiency wage theory. Why might a company operate under this theory? The company benefits in the following ways:

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