Market Clearing Wage and Efficiency Wage
In class, we learned about market clearing prices for items, such as parking lots, and how these prices result in a perfect matching in the preferred-seller graph. We can also apply this market concept to labour. In this scenario, we can think of labour as the item. The market clearing wage would then be the wage at which the supply of labour is equal to the demand for labour.
This idea of market clearing wage is similar to the market clearing prices in that buyers and sellers get what they want. In the examples we did in class, each buyer was able to get the item they wanted under market clearing prices. For the labour scenario, the buyers (employers) are able to get labour from the sellers (workers) under market clearing wages. If the demand for labour is equal to the supply of labour, theoretically, we can set up a bipartite graph that links each buyer to each seller.
It is more complicated, however, to actually set up a preferred-seller graph with perfect matching for the labour market. For example, the market clearing exercises we did in class allowed buyers to buy any of the items. In another words, the sellers cannot “refuse” to sell their item to particular buyers. In the labour scenario, however, the sellers (potential employees/workers) may not want to sell their item (labour) to certain buyers (companies/employers). An example of this would be if a person does not want to work for company A. Even though company A might want to “buy” or hire this person, if the person decides that he/she does not want to work at that company, then the company cannot actually buy that person’s labour. If the examples we looked in class dealt only with preferred-seller graphs, then the labour situation deals with both preferred-seller and preferred-buyer. This is due to the fact that the “items” are no longer actual items. It is people looking to hire other people for their labour, in which both sides can choose whether they want to be “matched” with each other or not.
What, then, is efficiency wage? Efficiency wage is a wage that is higher than the market clearing wage. If the company decides to pay efficiency wage to its employees, then the labour market is no longer at equilibrium. This goes the same for the non-market clearing prices we saw in class: if the prices are not market-clearing, there is no perfect matching, and therefore, there is no market equilibrium. However, the reasons behind the same phenomenon differ for the two cases. In the labour market, there is no equilibrium because if the companies decide to pay efficiency wage, they are hiring less employees, which creates an excess supply of and low demand for labour. This scenario generally leads to higher unemployment. For the examples we did in class, however, the equilibrium does not exist because there is no perfect matching–that is, there is equal amount of supply and demand, but the buyers are competing for the same item.
Although the two terminologies sound similar, market clearing prices and market clearing wages are different more than they are alike. Both create market equilibrium, but the reasons why are not the same.
Source: https://www.boundless.com/economics/textbooks/boundless-economics-textbook/unemployment-22/understanding-unemployment-104/efficiency-wage-theory-397-12494/