A second source of wage inequality is the phenomenon of efficiency wages—a type of incentive scheme used by employers to motivate workers to work hard and to reduce worker turnover. Suppose a worker performs a job that is extremely important but that the employer can observe how well the job is being performed only at infrequent intervals—say, serving as a caregiver for the employer’s child. Then it often makes sense for the employer to pay more than the worker could earn in an alternative job—that is, more than the equilibrium wage. Why? Because earning a premium makes losing this job and having to take the alternative job quite costly for the worker.

So a worker who happens to be observed performing poorly and is therefore fired is now worse off for having to accept a lower-paying job. The threat of losing a job that pays a premium motivates the worker to perform well and avoid being fired. Likewise, paying a premium also reduces worker turnover—the frequency with which an employee leaves a job voluntarily. Despite the fact that it may take no more effort and skill to be a child’s caregiver than to be an office worker, efficiency wages show why it often makes economic sense for a parent to pay a caregiver more than the equilibrium wage of an office worker.

The efficiency-wage model explains why we might observe wages offered above their equilibrium level. Like the price floors we studied in Chapter 5—and, in particular, much like the minimum wage—this phenomenon leads to a surplus of labor in labor markets that are characterized by the efficiency-wage model. This surplus of labor translates into unemployment—some workers are actively searching for a high-paying efficiency-wage job but are unable to get one, and other more fortunate but no more deserving workers are able to acquire one.

As a result, two workers with exactly the same profile—the same skills and same job history—may earn unequal wages: the worker who is lucky enough to get an efficiency-wage job earns more than the worker who gets a standard job (or who remains unemployed while searching for a higher-paying job).

Efficiency wages are a response to a type of market failure that arises when some employees are able to hide the fact that they don’t always perform as well as they should. As a result, employers use nonequilibrium wages to motivate their employees, leading to an inefficient outcome.