Some firms will attempt to increase their profits by improving their worker productivity by paying a wage that is above the wage paid by other competing firms. A well known example of the gains from this sort of wage setting is found in third world economies. At the market level wage, workers may not get the necessary nutrients they require in order to carry out the working day's hard labour and to maintain a healthy lifestyle. There is a vital correlation or interaction between a workers nutritional diet and their performance or productivity at the work site.
[...] Firms choosing to set wages above the equilibrium wage rate in order to maximize profits can be a very effective strategic labour policy. However, high paying organisations may not necessarily become high performing organisations because there may not be permanent wage differentials across firms. The existence of the efficiency wage model is highly dependent on the assumption that permanent wage differentials exist. This important criticism of the model is termed the bonding critique. If it is in fact true that there are no permanent wage differentials within the labour market, then workers will become indifferent between a job in a high wage industry and a job in a low wage industry. [...]
[...] These are rather plausible view held by firms who pay efficiency wages, as it is a view that is bound to hold in the real world. It has been mentioned once before in this essay that efficiency wages may not necessarily hold true in today's modern, industrialized economies. However, there is empirical evidence that efficiency can hold true in an industrialised setting and not just in a subsistence one. If this is the case, then the economic rationale behind firm's setting wages above the market clearing wage, is a sound rationale. [...]
[...] In conclusion, there are some crucial criticisms of the efficiency wage model that have the propensity to undermine the relevance of the theory and is some cases, irrationalise its practice by firms seeking to maximize their profits. Let one assume for instance efficiency wage theory has a diminutive marginal product as an explanation of wage stickiness; it will also have a negative marginal product as an explanation of market clearing unemployment. Albeit, in this regard, the efficiency wage theory does not consider the likelihood of entrepreneurial responses to efficiency wage model. [...]
[...] To demonstrate and critically examine how a firm sets wages in order to maximize profits, consider the straight line in figure 1 below, that comes from the origin and that is tangent to the total product curve at point X. Economic theory suggests that the straight line coming from the origin has a slope that is equal to the average product of say, a pound paid to labour. For instance, suppose that at point X the firm produces 200 units of output and pays a wage of The slope of the straight line is then equal 50 at that point. [...]
[...] Because paying a wage that is too high above the equilibrium wage will increase the firms wage bill and the increase in worker productivity will not be enough to compensate for additional labour costs. In order for the firm to reap the benefits of increases in labour productivity, the firm will have to identify precisely what wage is in fact the efficiency wage. This is the wage where the marginal cost of increasing the wage exactly equals the marginal gain in the productivity of the firm's workers[2]. [...]
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