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Wednesday, April 05, 2006

Are Efficiency Wages Less Efficient?

This article asks whether "Fordism," the idea that it's good for economic growth to pay high wages to support a prosperous middle class, is dead. The conclusion that it is comes as no surprise - there's no evidence to suggest a link between economic growth and the distribution of income:

The Economics of Henry Ford May Be Passé, by David Leonhardt, NY Times: Henry Ford was 50 years old, and not all that different from a lot of other successful businessmen, when he summoned the Detroit press corps to his company's offices on Jan. 5, 1914. What he did that day made him a household name. Mr. Ford announced that he was doubling the pay of thousands of his employees, to at least $5 a day. With his company selling Model T's as fast as it could make them, his workers deserved to share in the profits, he said.

His rivals were horrified. The Wall Street Journal accused him of injecting "Biblical or spiritual principles into a field where they do not belong." The New York Times correspondent who traveled to Detroit to interview him that week asked him if he was a socialist. But the public loved it. The country was then suffering a deep recession, and the Ford news seemed to offer hope. Within 24 hours, 10,000 men were lined up outside the Ford employment office in Michigan. The following year, Mr. Ford was mentioned as a future presidential contender.

The mythology around this story holds that Mr. Ford wanted to pay his workers enough so they could afford the products they were making. In fact, that wasn't his original reasoning. But others made the point, and, in time, it became part of Mr. Ford's rationale as well. The idea became a linchpin in an industrial philosophy known as Fordism.

More production could lead to better wages, which in turn would lead to more spending by the public, yet more production and eventually even higher wages. "One's own employees ought to be one's own best customers," Mr. Ford said years later. "Paying high wages," he concluded, "is behind the prosperity of this country." This turned into a pillar of 20th-century economic wisdom.

It's time to ask ... whether Mr. Ford's big idea is as ill suited to this century... By any reasonable standard, the last few years have been bad ones for most people's paychecks. ... But you would never know it by looking at the headline numbers on economic growth ... the last few years have been stellar. Despite two wars, soaring oil prices and business scandals, the economy has been growing more than 3 percent a year. ...

What was so comforting about Fordism was that it suggested that the economy operated on a virtuous, self-reinforcing cycle. Only when the middle class did well could the country do well. And as the country grew ever richer, so would the middle class.

In the last few years, however, the economy has kept growing in large part because high-income families ... have done so well... Globalization and new technology have helped many white-collar workers make more money, even as those same changes have closed factories and depressed wages for others. ...

Except for a span of a few years in the late 1990's, the hourly pay of most workers has done no better than inflation for the last 30 years. Even some Democrats, who have long embraced Fordism, are coming to the conclusion that Mr. Ford's reassuring cycle is not the only thing that can keep the American economy humming. "You don't need an equitable distribution to have a sustainable recovery," said Jared Bernstein, a liberal economist in Washington. ...

To explain falling wages in the framework of Ford's payment of wages above the market clearing level, another alternative is to turn to efficiency wage theory which explains why firms would pay wages higher than the market-clearing level. Common explanations for efficiency wages are given in this list from Wikipedia:

There are several theories (or "microfoundations") of why managers pay Efficiency Wages (wages above the market clearing rate):

  • Avoiding Shirking: If it is difficult to measure the quantity or quality of a worker's effort -- and systems of piece rates or commissions are impossible -- there may be an incentive for him or her to "shirk" (do less work than agreed). The manager thus may pay an efficiency wage in order to create or increase the cost of job loss, which gives a sting to the threat of firing. This threat can be used to prevent shirking (or "moral hazard").
  • Minimizing Turnover: By paying efficiency wages, the employees' incentive to quit and seek jobs elsewhere is minimized. This strategy makes sense because it is often expensive to train replacement workers.
  • Adverse Selection: If job performance depends on workers' ability and workers differ from each other in those terms, firms with higher wages will attract more able job-seekers. An efficiency wage means that the employer can pick and choose among applicants to get the best possible.
  • Sociological Theories: efficiency wages may result from traditions. Akerlof's theory (in very simple terms) involves higher wages encouraging high morale, which raises productivity.
  • Nutritional Theories: In developing countries, efficiency wages may allow workers to eat well enough to avoid illness and to be able to work harder and more productively.

Has globalization reduced the incentive to pay wages above the market clearing rate? For example, all else equal, has globalization made workers less likely to shirk or quit by raising the expected costs of unemployment, and are firms more able to attract high quality applicants? If so, and I would argue that they are, then the incentive to pay wages above the market clearing is reduced and this would explain, at least in part, a fall in wages.

    Posted by on Wednesday, April 5, 2006 at 12:12 AM in Economics, Income Distribution, Unemployment | Permalink  TrackBack (0)  Comments (15)


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