Efficiency wage

Efficiency wage theory proposes that firms may rationally pay wages above the market-clearing level because the benefits of higher wages — reduced turnover, increased worker effort, and better applicant quality — exceed the costs. Developed by George Akerlof and Janet Yellen, the model challenges the classical assumption that unemployment is merely a temporary disequilibrium.

In the efficiency wage framework, unemployment is a structural feature: firms cannot cut wages to clear the market because doing so would destroy the productivity gains that justify the premium. The theory connects information asymmetry in labor markets to persistent macroeconomic pathologies, suggesting that the same structural logic driving adverse selection in goods markets also distorts employment relationships.

The model has been applied to explain wage differentials across industries, the existence of dual labor markets, and the resistance of wages to fall during recessions — phenomena that competitive equilibrium models struggle to accommodate.