Sometimes paying people more makes them more productive

Economic View: There are some lessons from Janet Yellen's babysitter for the UK in the wake of the Chancellor’s decision to mandate a substantial hike in the minimum wage.

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In the early 1980s Janet Yellen needed to hire a babysitter for her son. She worked out the typical market rate for child minders in the area of Berkeley, California, where she lived. But then Yellen went and did something economically irrational: she put out an advert offering to pay a babysitter more than the market rate. She was acting on the hunch that by paying extra she would get a happier babysitter who would do a better job.

Yellen, who is now boss of America’s central bank, thinks she made the right decision. She was very pleased with her babysitter. That experience inspired Yellen and her husband, George Akerlof (also a distinguished economist), to develop a new theory of how labour markets work.

Classical economic theory says that employers will not pay workers more than strictly necessary because their profits would be smaller, and which capitalist would voluntarily choose smaller profits when higher ones are available? But Yellen and Akerlof argued that in practice workers (like their babysitter) are quite often paid more than the absolute minimum. Why? Because workers who are paid more than the market rate tend to be more productive. Sometimes firms are better off for paying more than the market rate. Yellen and Akerlof termed this the “efficiency wage”.

So why might this be the case? There are several explanations.

First, paying workers more than the bare minimum discourages them from shirking. They give more effort during their working day. And firms don’t need to employ so many managers to supervise their shirking workers, thus saving money.

Second, higher wages mean workers are keener to hold on to the job in question. They don’t hand in their notice so often and that reduces the firms’ turnover costs. It’s expensive and time-consuming to advertise for new employees, to interview them, to process their paperwork and to train them up. Finally, decent wages relative to the rest of the market can mean workers are more loyal. They feel more valued and are prepared to work harder as a result. Most of us can probably relate to those explanations.

Yellen and Akerlof also used this efficiency wages theory to tackle the puzzle of why economies sometimes get stuck in recessions with high levels of unemployment. In classical theory a surge in the supply of unemployed workers should enable employers to reduce their existing workers’ wages because others would do the same work for less money. The price of labour should fall, reducing employers’ costs, boosting their profits, prompting them to invest and hire more workers, thus reducing total unemployment.

But in fact this doesn’t happen. And, unless you’re a classical economist, it’s not particularly difficult to figure out why.

Imagine your employer sat you down one day and said: “Listen, the economy is in recession and there are plenty of unemployed people out there who would do your job for less money than you. Therefore I propose to cut your wages. Happy?” How would you respond? Would you say: “Yes, of course. I accept that it is economically rational for you to reduce my nominal wages at this time of surging labour supply.” Or would your response be unprintable in a family newspaper? I suspect the latter.

This is backed up by survey research that shows employers don’t cut wages in slumps because they are afraid of the effect that it would have on the morale and productivity of their staff who see their wages reduced. They pay efficiency wages. (Employers do, of course, freeze wages in cash terms in hard times, delivering a real-terms remuneration cut – but workers are much more willing to tolerate this kind of stealth pay cut rather than an outright reduction in their nominal salary, which offends their sense of fairness.)

These are some pertinent lessons here for the UK in the wake of the Chancellor’s decision last week to mandate a substantial hike in the minimum wage by 2020.

The move has divided economists. Some regard it as the most scandalous economic blunder yet committed by George Osborne, arguing that it is an idiotic attempt to interfere in the free labour market. They claim it will merely serve to push up firms’ costs, hit their profits and ultimately result in fewer jobs being created. Others are more relaxed, saying it will not do much economic damage, in part because better-paid workers are likely to respond to the pay rise by increasing their productivity.

There’s a more recent example. Last year it emerged that the wages of some employees of the American supermarket giant Walmart were so low that they were being forced to rely on food banks. In response to the popular outrage generated by that revelation Walmart hiked pay levels. Now the firm says staff turnover has fallen, reducing its total costs dramatically. Better-paid workers need not mean lower profits.

Of course there is a limit to how far one can buck the labour market. Mandating an overnight 50 per cent pay rise for everyone in the country would clearly not be met with an overnight 50 per cent surge in productivity. And those who argue that the Chancellor has ridden roughshod over the work of the Low Pay Commission – which until now has recommended increases in the minimum wage based on a careful estimation of what the market will bear – are surely right.

Yet at the same time predictions of economic calamity from a decent increase in the minimum wage are likely to be over the top. The truth is that no one fully understands what has been happening in the market for jobs in recent years. No one expected UK employment growth to remain so healthy despite the weak economy. And the reasons for the unprecedented flat-lining of national productivity remain a mystery. It’s not impossible that higher wages for low-paid service sector workers will help. Sometimes it’s worth acting on a hunch – as Janet Yellen did with her babysitter.