Efficiency Wages

The theory of efficiency wages state that companies are more profitable when paying wages above the minimum wage because higher wages increase workers' productivity.

There are four reasons why this is true. High wages attract high quality and high productivity workers with high reservation wages (minimum wages that they are willing to work for) to apply for the companies' jobs. Health (only applies to less developed countries) is another reason. Higher wages increase workers' nutrition and health and thus productivity. Higher wages give workers incentives to put more effort into their work because of workers' fear of unemployment (caused by higher wages) and inability to find a job that pays the same high wages. Higher wages prevent many workers from leaving and thus save huge costs from training new workers and from having new workers that are much less productive.

The theory of efficiency wages can also be explained by the principles of asymmetric information and moral hazard.

Asymmetric information of buyers and sellers in the market leads to adverse selection. Assuming firms cannot screen applicants and other jobs are available for the applicants, applicants hold more information about their abilities than do employers, lowering wages would be adverse to employers as truly qualified applicants leave. Insurance companies limit coverage and raise premiums to counter adverse selection caused by the buyers having more information about their health and risk. People tend to avoid downloading free softwares to counter adverse selection caused by providers having more information about them. People tend to avoid buying used cares to counter adverse selection caused by sellers having more information about them. Two major solutions for asymmetric information are signaling (e.g. college degree) and screening (e.g. interview).

Moral hazard is the risk that one party does not act in good faith according to the contract or agreement. In the case of efficiency wages, the employers (also called principal) have the moral hazard of employees (also called agent) not working hard enough on the behalf of their companies. So employers raise their wages, giving them incentives and the threat of unemployment. In commerce, salesperson (agent) without commissions will not try hard to sell for his sales company (principal) because his salary will be the same no matter what. In finance, "Too big to fail" institutions (agent) involve in risky practices because they know governments will bail them out. In insurance, an insured person (agent) will more likely drive or act recklessly and dangerously because they no longer bear costs for their consequences. Their insurance companies (principal) do. In management, managers (agent) often make risky decisions because other people bear their risks. One solution for moral hazard is placing responsibilities on both parties. Insurance firms raise premium after accidents. Salesperson gets a certain percentage of his sales.