Misconceptions of the Efficiency Wage Hypothesis

In an otherwise largely fair write-up of the disagreements and controversies surrounding the economics of minimum wage laws, a blog I was cited in yesterday made a common error in discussing the so-called “efficiency wage hypothesis.” Here’s the extract (my emphasis):

But if employers have monopsony power (they have enough market power to influence the wage rate in their industry) then the impact of a minimum wage is to raise employment (up to a point). Furthermore, the efficiency wage theory suggests that a minimum wage could help raise employment by increasing productivity and lowering turnover.

This last sentence is a misreading of economic theory.

Many do claim that higher minimum wages can lead firms and workers to improve productivity in ways that avoid job losses, whether that be through more worker effort, less staff turnover or whatever. And there’s no doubt that in some cases, firms and workers adjust in this way.

But the efficiency wage theory itself is actually a market failure theory of unemployment. It does not suggest that raising the minimum wage could increase employment. It suggests that in certain sectors where the costs of replacing labor are high, firms pay above market wages out of fear that lowering them would reduce their workers’ productivity substantially. The consequence is that the specific sectoral labor market does not clear, resulting in at best excess supply of workers in that sector (who subsequently have to find employment in other sectors at lower wages) or at worst more unemployment in the economy as a whole.

Instead the story that minimum wage advocates want to tell is that hiking statutory pay is costless for jobs because there are market failures in terms of firms misjudging the productive potential of their workers. In this story, companies that seek to maximize profits are simply missing opportunities to pay their workers more and get proportionately more out of them. We are stuck in a low-pay, low-productivity equilibrium from which a minimum wage hike can wrench us. The stories of individual companies successfully raising pay and boosting productivity are cited as evidence that minimum wages need not result in less employment on an economy-wide basis.

For reasons I have written before, this seems to be motivated reasoning. There are significant problems you have to think through before considering this theory plausible across a whole economy:

  1. Are significant numbers of existing firms really so irrational or ignorant about the productivity potential of their workers that the government is better placed to judge their potential through a mandated nation or state-wide wage rate?
  2. Can the experiences of certain companies really be replicated on an economy-wide basis? Or do the improvements that come from raising pay levels on productivity in a firm come about due to attracting and retaining better talent than competitors?
  3. If an increased minimum wage reduced job turnover, would this actually be good for the economy as a whole? Might it be that the higher wage now offered in traditionally low-skilled sectors reduces the incentive for workers to accumulate human capital to move to higher-skilled, higher-paying sectors over time? Might this actually reduce the dynamism and average productivity of the economy overall?

In short, for the advocates of significant minimum wage hikes to be right on this basis, the government would have to have better knowledge of firms’ profitability than firms themselves, and a better grasp of optimum turnover rates through the economy too.