Increased Wages Increase Productivity

Increased Wages Increase Productivity

Increased Wages Increase Productivity

Economists in the late 20th century began studying efficiency wage theory, which is the idea that increasing wages can lead to increased labor productivity.


In 1914 Henry Ford embarked on a radical idea which introduced the five-dollar a day salary, which was about double the going rate of the time. He did so to test what is now known as efficiency wage theories of wage and employment. Why did he do it? At the time, workers were getting bored working on the new efficient assembly lines, so he wanted to create an atmosphere where employees wanted to stay on the job. 

Ford thought that paying above the equilibrium wage would secure business for the future. He thought it would lower costs, and evidence shows that it indeed lowered production costs for the Ford Motor Company ever since he introduced the idea. 

What is Efficiency Wage Theory?

Economists in the late 20th century began studying efficiency wage theory, which is the idea that increasing wages can lead to increased labor productivity. If companies increase wages, those costs will be recouped through increased employee retention and higher productivity, which is in line with the thoughts of Ford back in 1914.

We can break down the theory into four parts that suggest benefits to companies.

1. Employees work harder

First, the theory suggests that when employees are paid a higher wage, they are less likely to slack off because the cost of losing their job is high. Other jobs in the same market may not pay the same wages so they have more incentive to put in the extra effort to keep their current position.

2. Lower turnover rates

The second part of the efficiency wage theory suggests that it reduces costly turnover. Employees look at the full spectrum of their current position and weigh it against a new opportunity. This may include wages, fringe benefits, and job opportunities. If the benefits of staying outweigh the cost of leaving, they will stick around. 

3. Attracting higher quality employees

The third part of the theory suggests that higher wages attract higher quality employees. Highly skilled employees are valuable to a company and often demand a higher wage.  They often have a predetermined lowest wage they will accept, so providing a higher equilibrium wage will attract more high-quality employees. 

4. Healthy employees

The last part of the theory suggests a direct correlation between wages, health and productivity. A higher wage gives the employee more options to take care of themselves through nutrition, sleep and stress reduction. Healthier employees result in higher productivity. 

The reasoning behind all four theories is companies make a profit from paying higher wages if benefits outweigh additional costs. 

A study done by Raff and Summers (1986) concluded that Mr. Ford’s wage increase was consistent with what was expected of efficiency wage theories. 

There is vivid evidence that the five-dollar day resulted in substantial queues for Ford jobs. Finally, significant increases in productivity and profits at Ford accompanied the introduction of the five-dollar day.

Raff, Summers “Did Henry Ford pay efficiency wages” (1986) NBER

Productivity increased because workers knew they had a better paying job than anywhere else, so they stayed with the company and they worked hard to keep their job. This raise in wages also increased the number of people wanting to work for Ford. 

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