17.4 Effects of Pay Level
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It’s not money that brings happiness, it’s lots of money.
(Russian proverb)Viewed from the perspective of neoclassical economic theory, individual employers
are assumed to be wage-takers, as opposed to wage-makers. In this view, wages are
determined by the market-level supply and demand for workers and, as price-
takers and proWt-maximizers, individualWrms will hire workers until the marginal
revenue generated by additional hires equals the cost of the market-determined
wage. From this traditional perspective, there is no advantage forWrms to deviate
from the ‘market’ rate. In fact, doing so would always negatively impactWrm
proWts. Both anecdotal and empirical evidence suggests, however, thatWrms vary
substantially in the amount of compensation oVered to employees. The Costco
example in the beginning of this chapter is one example. More formally, Leonard
( 1989 ) showed that wages for a similar job can vary by as much as 50 percent within
a given city. Moreover, while the economics literature tends to focus on human
capital and industry characteristics in explaining pay-level diVerences, research
suggests that organizations adopt distinct, stable market pay positions (Gerhart
and Milkovich 1990 ). What are the consequences associated with these diVerent
pay-level positions? As detailed below, the relevant body of work remains incom-
plete and somewhat inconsistent.
The ‘eYciency wage hypothesis’ (Akerlof and Yellen 1986 ) was developed to help
understand pay market positioning eVects and outlines several mechanisms to
help understand why paying above-market wages may sometimes be ‘eYcient’ or,
more colloquially, improveWrm eVectiveness. First, since workers will want to
maintain employment with their above-market employer, it will reduce the likeli-
hood of ‘shirking’ or performance problems. Second, above-market wages may help
by reducing turnover. Third, similar to equity theory arguments, employees may
increase their eVort and performance out of a sense of fairness. Fourth, above-market
employers may enjoy an advantage in terms of their ability to attract a more talented
pool of applicants. Several studies appear to validate a number of these arguments.
A clever study of the eYciency wage hypothesis was conducted by Cappelli and
Chauvin ( 1991 ). They used data on seventy-eight plants from a single USWrm to
examine the relationship of wage rates with employee dismissal for disciplinary
reasons (e.g. due to low performance, absenteeism, tardiness, etc.). While all plants
were under the same national contract, cost-of-living diVerences in diVerent
locations led to signiWcant diVerences in employees’ ‘real wages.’ Consistent with
eYciency wage predictions, Cappelli and Chauvin found that higher (real) wages
reduced ‘shirking’ and discipline-related dismissals, with the eVect magniWed with
increases in local unemployment rates.
356 james p. guthrie