I. The Main Point
It’s all about MB = MC.
In basic economics, firm productive efficiency is maximized when the marginal benefit (MB) equals marginal cost (MC). At the employee level this efficiency is maximized when wages = marginal product of labor.
An employee paid at salary on a 40 hour work week has no marginal benefit from work in excess of 40 hours. Why would anyone keep working at that point? Some people do and we talk about that more in section II, but it’s a minority case and only serves to reinforce the lesson learned in the main case. In the main case people don’t like to continue working for no additional pay.
When a firm pays a flat salary they are efficient at the weekly level only in the case that the employee’s marginal product of labor per week is exactly equal to the salary per week. However, employee productivity at the weekly level varies strongly. Salary cannot adjust for this. As a result, firms are paying a fixed price for variable product. This variability is inefficient.
Now suppose that employees whose marginal product at the weekly level exceeded their salary at the weekly level were given permission to continue working, on an hourly basis, until their marginal product equaled their wages. These employees would earn more, and the firm would obtain lower price per unit produced. In addition, these employees are likely to be the highest performers in the company. They would have a disproportionate incentive for retainment.
Equity does a similar thing. In particular, when stock options are pegged to time in the company. For many start-ups, stock options can’t be sold until the IPO happens. This may be 3-5+ years out from the time of hiring a particular employee. This employee then receives an incentive to remain at the company for 3-5+ years, which is a lengthy term for, say, programmers these days.
II. Secondary Cases and Other Notes
What about the case where an employee does continue to work over 40 hours, despite lack of additional pecuniary benefit? The obvious economist retort is that there are marginal non-pecuniary benefits. Here are two main reasons for such continued work:
- The employee is behind their expected productivity goals and is working extra hours to make up for it. The marginal benefit is a reduction in the odds of losing face or employment.
- The employee wants to look extra awesome to their employer, perhaps to facilitate career advancement or a future raise.
Obviously the first effect is bad and the second is good. If your firm has decent productivity metrics it’s usually easy to sort these kinds of employees out, but there is a problem: The second group, the better group, is a flight risk and as an employer you need to hold on to them.
In psychology, it’s well known that people experience stronger negative emotions in relation to a fixed-level loss compared to the positive emotions they experience for a positive gain. So even if your firm tries to improve hiring and retainment through efficiency wages, or higher-than-average wages, there will be periods of inefficiency when salary is used. There will be periods of time where the employee correctly feels underpaid for several hours of unpaid overtime work, and these moments, even if rare, will tend to disproportionately counteract any benefits from efficiency wages.
Spot bonuses are another non-starter. Because employees can’t count on spot bonuses, their incentivizing effect is diminished. Employees will treat such money as a windfall, not an increase to salary. Windfall payments do not typically effect labor productivity in a sustainable way in most economic models, and businesses recognize this in practice.
Banks have substantially heightened lending requirements for the consideration of bonuses vs regular income, and extended work week or overtime income is considered regular as it is reported on a W2. My wife earns bonuses and the bank issuing the loan on our house recognized the average of the past two years of bonus income, but the past two pay periods for W2 income.
I would encourage firms going through any of the following to consider instituting EWW instead of a flat salary increase:
- Hiring or retention issues
- Looking to increase employee benefits
- Looking to give an extra reward to the hardest working employees