How Low Wages Reduce Productivity and Effectiveness

The opposition to paying a living wage is generally couched in terms of competitiveness: if employers are forced to pay more, this theory holds, they will have to pass on the cost to customers who will then search elsewhere for a cheaper product and, eventually, the work will flow to lower wage countries. QED.

It turns out, however, that pay minimal as opposed to minimum wages actually detracts from institutional competitiveness by distracting employees, rendering them less productive and effective. The source of the reduction in efficiency is the worry about how to make ends meet, help provide for a family, pay the rent, cover doctors' bills, food, commuting expenses and the like. As the following article explains, the putative savings from forcing down compensation is likely to be offset - or more so - by the lost productivity that results.

The steady increase in executive compensation despite years of recessionary economic conditions suggests that the wherewithal to support rising pay exists. It is the distribution of those funds that is in question. Logic dictates that there are relatively few jobs that really pay by comparative and historical standards. It would therefore appear to be more strategically sensible to divert some of the potential gains at the top to those lower down. This does, of course, presuppose that logic rather than other factors governs such decisions. JL

Alex Mayyasi reports in Priceconomics:

Even when excess labor is plentiful and people are desperate for jobs, it may be worthwhile from a self-interest, business productivity perspective to offer wages that provide a minimal sense of financial security to workers. Otherwise employees will spend all their mental energy thinking about money problems and none on their work
With the United States enduring a “jobless recovery,” Americans are asking why unemployment is so high and wages are so low. Continued unemployment is a puzzle for economists, but for a different reason. Economists puzzle over why wages don’t lower until unemployment disappears entirely.

This is not an in-the-moment debate but rather a longstanding part of economic theory. If unemployment exists in a field, the theory asks, then why don’t employers use the leverage of available labor to decrease wages and hire more until unemployment disappears? 

For unskilled labor, the answer is often minimum wage. This author vividly remembers learning that in poorer countries where minimum wage is either very low or weakly enforced, one explanation is that employers pay higher wages because the minimum they could pay would not keep employees nourished. Paying enough for the employee to have half a chance at good health and performing a hard day’s work improves productivity. 

Wages paid above the point where labor supply and labor demand meet are called efficiency wages. Wikipedia summarizes some of the arguments for their existence: 

1) 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").

2) Minimizing turnover: By paying above-market wages, the worker's motivation to leave the job and look for a job elsewhere will be reduced. This strategy makes sense because it is often expensive to train replacement workers.

3) 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, and this may make it profitable to offer wages that exceed the market clearing level.

4) Sociological theories: Efficiency wages may result from traditions. Akerlof's theory (in very simple terms) involves higher wages encouraging high morale, which raises productivity.

5) 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 even more productively.

(Diligent readers can read a more thorough overview in this paper from economist Lawrence Katz.)

The theories for efficiency wages seek to explain wage premiums and unemployment for account managers as well as line cooks at Burger King, so these explanations’ relevance to the lowest paid positions varies. 

Unions and collective action should be added to this list. And while the nutritional theory can seem irrelevant in the US, that is arguably only because welfare programs like food stamps, Medicaid, and low-income housing shift the responsibility for ensuring that workers are healthy enough to be productive from their employers to the government. Given the desperation of workers to get a job in the present circumstances, however, the shirking and minimizing turnover explanations aren’t as powerful, which helps explain stagnant incomes.

A study published in Science last month suggests another reason why companies should pay efficiency wages and not minimum wages. 

In the paper, the authors argue that the financial worries of poverty impair individuals’ ability to think clearly. Like trying to concentrate while distracted by thoughts of a sick loved one or ongoing tragedy, financial concerns distract from work and decision making. 

The authors collected evidence for their hypothesis by recruiting Americans of varying means, priming them to think about financial concerns like paying for car repairs, and then asking them to perform two tasks on a computer - one in which they applied logic to novel puzzles and a second that called for attention and control over quick decisions. A second experiment asked poor farmers in rural India to perform similar tasks before and after they sold their annual crop to earn their entire yearly income. 

In both cases, those with pressing financial concerns did dramatically worse. Worry about financial concerns led to reduced performance of about a quarter - an effect comparable to losing a full night’s sleep. 

This strikes us as a good argument for an efficiency wage above the minimum that an employer could pay. We may use the words “unskilled labor,” but those making minimum wage or close to it are not automatons. Productivity still hinges on mental sharpness.