Minimum Wage and Efficiency Wage Theory

Topic: Economics
Words: 1138 Pages: 4

Equilibrium Wage Rate

Minimal wage is the state’s payment for all employees per hour. Each country calculates minimal wage based on various economic factors such as consumer and production spending. The increase or decrease of the minimum wage causes many changes in the country’s financial system. The increased minimum wage can significantly affect the inflation level (Adao et al., 2020). One of the primary reasons for such a change is the enhanced spending on production by the firms. Economic theory implements such a term as an equilibrium wage rate. It is defined as the conditions when the labor demand and supply are balanced (Adao et al., 2020). The minimum wage can be set above the equilibrium wage rate, which will cause particular changes.

In a market economy, an equilibrium wage is a rate at which the demand for labor is equal to its supply. The balance of demand and supply of labor is maintained with the help of market self-adjustment, which is a systematic correction of wages by each firm and organization, taking into account changes in its equilibrium value. An increase in wages accompanies the demand for a particular type of labor, and, conversely, a decrease in demand leads to a reduction in wages (Adao et al., 2020). Demand in the labor market shows how many workers employers would like to get at the regular wage rate. An equilibrium wage establishes the price of capital while the level of demand for the product remains unchanged.

An excessive labor supply will appear if the minimum wage is higher than the equilibrium wage rate. As a result, the surplus of labor will be noted within the market, which can potentially cause an increase in unemployment rates. The amount of labor offered exceeds the demand for labor, causing unemployment. The excess of wages over its equilibrium level cannot continue for long because the demand for labor from the employer decreases. Thus, the decrease in wages to the equilibrium level and lower as a result of an excess supply of labor will appear (Adao et al., 2020). Then the opposite process begins, returning wages to the equilibrium level and above. The oscillatory nature of achieving equilibrium in the labor market indicates that both situations cannot be sustainable.

Minimum Wage Supply and Demand Graph

The minimum wage is formulated based on the demand and supply factors. In the situations when the labor supply is equal to the labor demand, the equilibrium wage rate is established. On the contrary, unemployment occurs when the supply of labor is higher than the demand. The mechanism demonstrating the correlation between the labor demand and supply in relation to the minim wage is represented in Figure 1. Q is the number of employed; W is the wage rate; S is the labor supply; D – is the labor demand, and e is the equilibrium wage rate.

Figure 1.

Efficiency Wage Theory

According to the efficiency wage theory, the level of exceeding competitive wages increases productivity. Firms set rigid real wages even in competitive labor market conditions. If real wages are rigid, then the level of employment will not necessarily correspond to the level of employment. Therefore, the theory can explain the existence of unemployment. It is also customary to refer to the natural rate of unemployment as classical unemployment caused by the inflexibility of real wages, which, unlike frictional and structural, cannot be recognized as absolutely voluntary (Mankiw & Harris, 2001). The reason for classical unemployment is the establishment of actual real wages at a level exceeding the real equilibrium wage (Acharyya et al., 2020). This may be a consequence of the minimum wage law, which prevents firms from reducing the income of workers even when there is a surplus of labor.

Wages set to stimulate the labor efforts of workers and minimize costs above the equilibrium for a competitive labor market are called efficiency wages. Theoretical implications of the efficiency wage are not valid for a minimum wage. The efficiency wages usually exceed the market equilibrium level. The higher minimum wage increases the general cost of living and poverty rates. As a result, the balance of work distribution among workers may be disturbed. For example, less experienced workers can become victims of job losses because of the minimum wage law. Therefore, the total increase in wages aimed at improved efficiency becomes irrelevant. Less experienced workers are not likely to be paid higher wages because their skills are not profound enough. The efficiency wage theory implies that increased wages will increase the motivation of employees to work more productively (Saccal, 2021). However, the economic implications of such increases in the minimum wage case are adverse. The labor costs, as well as the cost of final products and services, will be increased. Therefore, the total rise in wages will be insufficient due to mentioned economic consequences.

Elasticity Conditions and Minimum Wage Related to Low-Income Workers

The income elasticity of demand and supply reflects the change in demand and supply for particular goods, services, or labor in relation to the consumers’ incomes. The low-income workers strive to improve their wages. In the case of the established minimum wage, such workers are in unfavorable conditions because it is more complicated to improve their salaries without upgrading their skills (Okudaira et al., 2019). However, such workers have no developmental opportunities because they need to work harder to make a living. The elasticity of the demand and supply of the workers should be lower. It will be less complicated to strive for wage improvements in such conditions. In other words, the elastic demand and supply in the increased minimum wage conditions cause job losses and an increased unemployment rate. It is caused by the fact that elastic labor demand and supply cause a surplus of the working forces (Okudaira et al., 2019). The inelastic labor demand and supply also cause unemployment. However, the general rates are estimated to be lower than in the case of elastic conditions.

Elastic labor demand determines the correlation between insignificant changes in wages and significant changes in the number of employed workers. Elastic demand means that the workers are of low value and can be replaced with some production mechanisms or other workers. Such conditions are disastrous for low-income workers as far as their skills and labor can be easily replaced. On the contrary, inelastic demand and supply refer to the situation when labor cannot be replaced with capital. If the demand and supply are inelastic, people who currently work or seek employment opportunities are not directly affected by the changes in the wage (Okudaira et al., 2019). Moreover, the employees seeking jobs with minimum wage will require no additional training because their skills will be more appreciated. Therefore, inelastic conditions are needed for the minimum wage to benefit low-income workers.


Acharyya, R., Ganguly, S., & Sugata, M. (2020). Minimum wage, trade and unemployment in general equilibrium. International Journal of Economic Theory, 17(1), 74–87.

Adao, R., Arkolakis, C., & Espositom F. (2020). General equilibrium effects in space: Theory and measurement. National Bureau of Economic Research, 25544, 1–63.

Mankiw, G. & Harris, R. (2001). Principles of microeconomics. Cengage Learning.

Okudaira, H., Takizawa, M., & Yamanouchi, K. (2019). Minimum wage effects across heterogeneous markets. Labour Economics, 59, 110–122.

Saccal, A. (2021). Efficiency wage efficiency: In theory and in time. Journal of Applied Economic Sciences, 72, 139–149.

Laws of Economics: Model of Supply and Demand
Impact of International Economic Conditions, Trade and Financial Policies on Brazil