September 2014

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Peter,

My, admittedly weak, understanding of the purpose of 'efficiency wages' is that it tries to explain why firms often pay compensation above market rates for a given level of productivity in the provision of current labor services, adjusting for benefits and relevant individual aptitudes.

The main problem with this is that it makes an unwarranted assumption that the cash portion of compensation is entirely aimed at current labor services. In fact, firms with available profits may invest part of those profits in premium cash wages to compete for those potential employees who are judged to have future benefits for the firm (a higher quality future promotion pool, for example) which have nothing to do with current labor services.

To the extent that this may be true, it means that any empirical study of labor services compensation will include an error that not even the firm can adjust for.

If firms didn't do this, they would expend much less effort in ranking candidates for employment and just pay a market level wage for any qualified provider of current labor services. Instead, they consider candidate intangibles to see if they are worth investing premium wages in.

Regards, Don

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