What theory suggests that paying workers above-market wages can increase productivity and reduce turnover?

The theory that paying workers above-market wages can increase productivity and reduce turnover is efficiency wage theory.

The idea is that a wage can affect behavior, not merely compensate workers for output. A premium wage may make employees work harder because losing the job becomes more costly, reduce costly resignations, attract stronger applicants, and improve morale. These channels can make the higher payroll profitable if productivity or retention gains outweigh the extra wage expense.

Economist Alfred Marshall discussed related ideas, while modern efficiency-wage models developed prominently in twentieth-century labor economics. Carl Shapiro and Joseph Stiglitz’s 1984 shirking model explained how above-market pay can discourage employees from reducing effort when employers cannot perfectly monitor them. Efficiency wages can also help explain persistent involuntary unemployment: firms may prefer a wage above market-clearing levels, leaving more workers seeking limited well-paid jobs.

A common mix-up is confusing efficiency wages with minimum wages. A minimum wage is a legal pay floor; an efficiency wage is a voluntary employer strategy. The theory also does not claim that every raise increases productivity—its prediction depends on monitoring costs, turnover, worker morale, recruitment, and the type of work.