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Do Governments Pay Efficiency Wages? Evidence from a Selection of Countries
Paper presented at the 2009 International Public Service Motivation Research
Conference, Bloomington, Indiana,
June 7-9 2009.
Dr Jeannette Taylor
Political Science and International Relations (M259)
The University of Western Australia
Stirling Highway
Crawley
Western Australia 6009
Australia
Email: [email protected]
Dr Ranald Taylor
Murdoch Business School-Economics
Murdoch University
South Street
Murdoch
Western Australia 6150
Australia
Email: [email protected]
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Do Governments Pay Efficiency Wages? Evidence from a Selection of Countries
Abstract
The issue of how much to pay government employees without risking a drop in their
public service motivation (PSM) levels is a complex one. On one hand, it is argued
that government employees are generally less motivated by high wages than their
private sector counterparts. Governments too are constrained in their ability to offer
high wages to their employees. There is also the proposition that high wages,
particularly performance-based wages, can reduce or ‘crowd out’ intrinsic motivation.
On the other hand, it is common knowledge that most people do not seek employment
without expecting some sort of remuneration for their effort. Wages can satisfy both
lower-order and higher-order needs, and can be used to indicate achievement and
recognition for one’s effort. This paper argues for the significance of ‘PSM-adjusted
wage’, the level which ensures high effort without undermining PSM levels in the
public sector. It draws upon the efficiency wage theory and the PSM literature to
construct a model for PSM-adjusted wage, which is then piloted on the 2005 ISSP
dataset of fifteen countries that include USA, Great Britain, and Australia.
3
Introduction
The issue of how much to pay government employees in order to ensure maximum
effort levels and without risking a drop in their public service motivation (PSM)
levels is a complex one. Efficiency wage theory dictates that paying employees above
the market clearing rate or a wage premium guarantees maximum effort (Solow
1979). The literature of PSM presents a different perspective. It states that employees
with high PSM levels are more motivated by a desire to serve the public interest than
by obscenely large sums of monies (Perry and Hondeghem 2008; Perry and Wise
1990). But the fact that these high performing employees are strongly driven to pursue
the common good should not be taken to imply that employers can get away with
paying them extremely low or minimum wages. After all, most people choose to work
because of their desire and/or need to earn an income (Latham and Locke 1992). In
short, wages can satisfy both lower-order and higher-order needs (Pinder 1984;
Rainey 1991).
This paper’s exploration of the complex relationships between effort, wages and
PSM in the public sector will address four specific questions. First, are governments
in selected countries paying their public sector workforce efficiency wages? Second,
what is the relationship between efficiency wages and effort? How much do these
governments need to pay in order to raise the effort levels of their public sector
workforce according to the efficiency wage specification? Third, what is the
association between PSM and effort? How much change in PSM is associated with
effort change? In combination, the second and third questions allow us to find out
which of these two factors – wages or PSM – accounts for a larger change in the
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public sector workforce’s effort levels. Fourth, what is the relationship between
‘PSM-adjusted wages’ and effort? How much change in wages is related to a change
in effort when PSM is taken into account? This article makes a distinction between
efficiency wages and ‘PSM-adjusted wages’. An efficiency wage is the level of wage
that is higher than the prevailing market rate, which elicits maximum effort. A ‘PSM-
adjusted wage’, on the other hand, is defined as the amount that is associated with a
high effort level without undermining the PSM level.
We will begin this article by reviewing the literature on the significance of wages
as a way to raise employees’ effort in the public sector. Two perspectives will be
presented: Solow’s (1979) efficiency wage model, and the PSM literature. A simple
framework will then be formulated to explain the relationships between effort, wages
and PSM. We will pilot this model with the 2005 ISSP dataset. Fifteen countries in
the dataset are selected for the analysis. They include USA, Canada, Great Britain,
Australia, New Zealand, several countries in Europe (e.g., Denmark and France) and
Asia (Japan and Taiwan), Israel, and Russia.
An efficiency wage perspective on wages and effort
The central argument in Solow’s (1979) efficiency wage model is that unless
employers offer wages higher than the prevailing market rate, or efficiency wages,
employees will engage in unproductive activities, such as shirking, and ultimately
switch jobs.1 A low wage relative to the prevailing market wage can contribute to
dissatisfaction, and other negative attitudes amongst employees (e.g., outrage and a
desire for revenge), thereby leading to an increase in shirking or sabotage activities
5
(Akerlof and Yellen 1986). In a Walrasian labor market, employees are indifferent to
their jobs because there are similar paying jobs available in the labor market. As a
result of this indifference to jobs, employees are less likely to exert high effort and are
more likely to shirk. In the worst case scenario, if they are fired from their jobs for
substandard performance or shirking activities, this will have a minimum impact on
them because they can always find another job in a Walrasian labor market (Wood
1993).
Shirking occurs because of asymmetric information. Unlike employees, employers
do not have complete information about their employees’ work habits and practices,
and how much effort the employees have put forth to achieve the organization’s goals.
The fact that a typical employment contract can specify the number of hours that
employees need to work per day means that an organization can buy employees’ time,
but not employees’ effort. The fact that labor quality cannot be observed by
employers prior to employment, as alluded to by moral hazard and adverse selection
problems, suggests that it pays to offer higher relative wages in order to minimize the
risk of taking on less productive employees.
Organizations which pay more than the market-clearing wage or a wage premium
can raise the costs to workers of shirking (Shapiro and Stiglitz 1984). Employees who
are paid wages that are higher than their peers in comparable jobs may place more
value on their jobs than those in less-paid positions. These employees perceive that
they will have more to lose if they are caught shirking and consequently lose their
jobs. Even if there is a chance that they will not be caught if they engage in shirking,
they may still wish to minimize or avoid shirking and instead choose to exert higher
6
effort levels because of the heightened importance placed on their efficiency wages.
In addition, the ‘gift exchange’ analysis undertaken by Akerlof (1982) and Kaufman
(1984) explains that high relative wages can increase employees’ identification with
their organization. High relative wages, it is argued raise employees’ general
willingness to cooperate and reciprocate in the employment relationship in that ‘My
employer treats me well so I will return the favor’.2
If one takes the view that the quality of a workforce affects the effort of the
workforce, then high relative wages may arguably ensure a high quality workforce
through recruitment and retention (Stiglitz 1996, 1974; Weiss 1980). Efficiency wage
theory explains why most organizations believe that they can fill their vacancies more
quickly with high quality workers if they raise their relative wages. Cable and Judge
(1994) suggested that wage is a signalling device for recruits. Wage premiums also
affect retention. They reduce turnover and the disruption caused by turnover (Stiglitz
1974). Henry Ford was perhaps the first modern employer to use efficiency wages to
reduce workers’ turnover during the production of the Model T. By paying $5 above
the market prevailing wage, labor turnover was reduced significantly, resulting in a
large increase in the production of the Ford Model T, making it the highest selling
automobile during the early 1900s (Raff and Summers 1987). Efficiency wage theory
clearly points to a significant association between high relative wages and effort. The
next section will present an alternative perspective on this relationship.
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A PSM perspective on wages and effort
The importance of PSM on effort, or more specifically, performance, has been raised
in the literature: ‘High performance is central to the theory of PSM’ (Brewer and
Selden 1998, p. 425). Past research has demonstrated that employees’ PSM is related
to how well they perform their jobs (Alonso and Lewis 2001; Brewer and Selden
1998; Bright 2000; Naff and Crum 1999). Drawing from job design research findings,
Perry and Wise (1990) propose that job characteristics can have a motivating impact
on effort. Attributes in the public service that are likely to appeal to those with high
PSM levels include those that provide opportunities to address questions of social
equity, pursue social programs, advocate a valued special interest, and express loyalty
to country. Wright (2004) clarifies that if government employees, who are motivated
to make a worthwhile contribution to society, perceive that their work is important to
accomplishing organizational goals that benefit society, then they will exert higher
effort levels.
In contrast to effort, wages are reported to be not significantly related to PSM
(Crewson 1997; Houston 2000; Perry and Wise 1990). Most public-private sector
studies maintain that public sector employees are less motivated by the extrinsic
aspects of their work, and more motivated by the intrinsic features, particularly an
opportunity to help others (Lawler 1971; Rainey 1982, 1991; cf. Gabris and Simo
1995). Similarly, various studies show that students who aspire to enter this sector
have less interest in monetary rewards than their counterparts who intend to join the
private sector (Chetkovich 2003; Taylor 2005). According to Frey and associates
(Frey 1997; Frey and Jegen 2001), high amounts of extrinsic rewards, such as high
8
wages, can have a ‘crowding-out’ effect on employees’ intrinsic motivation. For
example, when employees perceive the wages to be controlling, their self-
determination and self-esteem can suffer, and they can respond by lowering their
intrinsic motivation.
But these findings do not deny the relevance of offering wages to government
employees in order to raise their effort levels. People can have different motives for
serving the public interest, and they include rational motives (Rainey 1982; Perry and
Wise 1990). In her study of Australian government employees, Taylor (2007) found
the rational motives in the PSM construct to be significantly associated with
organizational commitment. Although wage did not occupy the top five positions of
employees’ preferences, it was found to be an important factor for recruitment and
retention in a government-commissioned survey of graduate employees in the
Australian federal government (Management Advisory Committee 2003). Taylor’s
(2005) survey of university graduates found that whilst the respondents who favored
the private sector were more motivated by a high wage than their counterparts who
were attracted to the public sector, the latter group was more concerned about a
comparable wage than the former group. Frey (1997) stated that wages which are
perceived as fair will support work morale, and have a ‘crowding-in’ effect on
employees’ intrinsic motivation. This implies that the public sector should aim to
achieve a balance between providing adequate economic rewards without
undercutting the service needs of government employees (Crewson 1997; Le Grand
2003). In particular, consideration should be given to paying employees wages at a
level that encourages them to put forth greater effort without risking a drop in PSM.
This level is proposed as the ‘PSM-adjusted wage’.
9
The research framework
This research framework is divided into two parts. We begin our analysis with the
efficiency wage model, followed by the PSM-adjusted wage model. Under the
efficiency wage model, effort (E) per employee (i) is a function of the employee’s
wage inside the organization (Wn) relative to the expected prevailing wage outside the
organization (We). Employees will work harder if they are convinced that they are
being treated relatively well (Akerlof 1983; Akerlof and Yellen 1990; Shapiro and
Stiglitz 1984). This relationship between effort and wages can be summarized in the
equation below.
Ei = e (Wn/We) e1, e2 > 0 and e11, e22 < 0 (1)
where e is the elasticity of effort, and e1 and e2 are the first derivatives, and e11 and e22
are the second derivatives of equation (1).
The second derivatives in equation (1) suggest that wages are subject to
diminishing returns. The relationship between wages and effort follows an inverted U-
shaped curve. Figure 1 indicates that at point A, the wage paid is W0 and effort is E0.
An increase in wages raises the effort level of employees. This will continue until
point B which represents the optimal level of effort En*. At this point, the wage is at
Wn*, which is the efficiency wage. Beyond point B, subsequent increases in wages
will cause effort to fall. An increase in wages from Wn* to Wn will result in a decline
in effort from En* to En.
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Figure 1: The relationship between effort and wage
Ei = e(Wn)
B
0
W0 Wn* Wn
E0
En*
A
Effort
Wages
Two possible reasons are presented to explain why an increase in wage beyond
Wn* will lead to a reduction in effort. The first is derived from the backward bending
labor supply curve (Gravelle and Rees 2004). Orthodox labor supply models tend to
predict a positive labor supply reaction to increases in wages. Employees would
substitute labor with leisure, and vice versa. They would supply more labor when
wages are high, and consume more leisure when wages are low (Lucas and Rapping
1969). Although this prediction is straightforward, it is difficult to verify and not
universally accepted. For instance, Camerer et al. (1997) found negative elasticities on
the labor supply of New York cabdrivers, which suggests the existence of a backward
labor supply curve in the New York cab industry. Once cabdrivers met their daily
income target, they quit working. This implies a particular work/leisure preference
function where the negative income effect outweighs the substitution effect of a wage
rise. This is always an empirical question for a particular type of labor supplied.
Similarly, in his writing on happiness, Frey (2008) stated that although a higher
income can make people happy, the higher utility derived from material goods will
11
wear off as people adapt to the higher income level. He reasoned that satisfaction
comes from change, and disappears with continued consumption.
The second reason for the drop in effort with an increase in wages beyond the
optimum point can be drawn from the body of literature on the negative impact of
high levels of extrinsic rewards on intrinsic motivation, as mentioned earlier in the
PSM literature. High levels of wages have been reported to undermine or ‘crowd-out’
intrinsic motivation (Deci 1971, 1972; Frey 1997). They are argued to undercut
employees’ PSM levels (Crewson 1997; Le Grand 2003), which can drive down their
effort levels.
The relationship between effort and PSM can be described as
ef = PSM/Ei ef1, ef2 > 0, and ef11, ef22 > 0 (2)
where ef = the elasticity of effort with respect to PSM, and Ei = Wn/We. High
PSM raises effort (Alonso and Lewis 2001; Brewer and Selden 1998; Bright 2000),
and reduces the dependence of wages on effort based on the argument that high wages
can undermine PSM (Crewson 1997; Frey 1997; Le Grand 2003).
To find the optimum efficiency wage (e) and PSM-adjusted wage (ee), the
equation below is utilized.
e = Ei /Wn = 1, and ee = PSM/Wn = 1 (3)
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Operationalizing equation (3) is done by taking logarithms of the variables (∂log
Wn/∂log Ei and ∂log PSM/∂log Wn). The relationship between PSM and effort is
captured by the elasticity of PSM with respect to effort (ef = ∂log PSM/∂log Ei).
Method
Sample
This study utilizes the 2005 International Social Survey Programme (ISSP): Work
Orientations dataset in fifteen countries. They consist of USA, Canada, Great Britain,
Denmark, France, Germany, Spain, Bulgaria, Slovenia, Russia, Israel, Japan, Taiwan,
Australia, and New Zealand. Only respondents who participated full-time in the labor
market, and those working in the public sector and private sector are taken into
account. The private sector respondents include self-employed individuals. The
sectoral division permits relative wage to be determined. The total number of
respondents was 9,742. The mean age of the respondents was 41.7 years. A majority
of them were males (57%), and married (63%), held higher than secondary school
qualifications (26%), and worked an average of 40 hours per week (32%) in the
private sector (70%).
Measures
The ISSP dataset provides two measures:
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1. Wages. This is derived from the respondents’ annual income (expressed in the
country’s currency). A mean wage is then calculated for each country by
sector.
2. PSM index. This is estimated from two items: ‘A job that allows someone to
help other people’; and ‘A job that is useful to society’. On a 5-point Likert
scale, ranging from ‘not at all important’ (1) to ‘very important’ (5), the
respondents indicated the importance they personally placed on the existence
of each item in a job. An average score of the two items is calculated for each
respondent. Factor analysis (principal component, varimax rotation) of the two
items measuring the PSM index revealed a single construct. Cronbach’s alpha
= 0.79
The above data are used to estimate efficiency wage ratio (government wages/ private
sector wages), the elasticity of effort with respect to wages (e), the elasticity of PSM
with respect to effort (ef), and ‘PSM-adjusted wages’(ee), as specified in equation (3).
Findings
The findings are presented in Table 1. The first column in the table shows an average
efficiency wage ratio above unity, which conforms to the efficiency wage
specification. The value of 1.03 implies that most governments in the 15 countries,
such as Australia and New Zealand, were paying their public sector employees
slightly above the market rate or efficiency wages at that time. The exceptions were
USA, Denmark, France, Bulgaria and Russia. Public sector employees in these
countries were paid below the prevailing market wages.
14
On average, the elasticity of effort with respect to wages, e, was estimated to be
0.25. This implies that governments in the selected countries which wish to increase
their employees’ effort by 1 per cent will need to increase their public sector wages by
0.25 per cent. The comparatively high e value in some countries, such as that in
Bulgaria and Spain, implies that these governments will need to pay higher wages in
order to bring about a similar rise in effort of 1 per cent amongst their public sector
workforce. The smaller the value of e, the smaller the governments will need to pay
their public sector workforce to raise their effort. Countries which show relatively
small e values are Denmark and USA.
The third column in Table 1 shows a mean elasticity of PSM with respect to
effort, ef, of 0.62. This implies that, for every one percent increase in the effort level
of the public sector workforce in the 15 countries, PSM contributed 0.62 per cent to
that one per cent. A higher ef value suggests the greater importance placed on PSM to
bring about a change in effort. For instance, on average, a 0.68 per cent increase in
PSM levels amongst the American public sector workforce contributed to a 1 per cent
rise in their effort level. In comparison, a similar rise in effort level amongst the
Japanese counterparts is derived from a 0.58 per cent increase in their PSM levels.
The finding also points to the significance of PSM amongst the public sector
workforce in the 15 countries in bringing forth a rise in effort relative to wages, as
evident by the higher ef values compared to the e values for every country.
The last column in Table 1 reports on the ‘PSM-adjusted wage’ (ee). It
demonstrates that when PSM is taken into account, government employers require a
smaller increase in wages to bring about a rise in effort. On average, a 1 per cent
15
change in effort is associated with 0.25 per cent change in efficiency wages, relative
to 0.16 per cent change in PSM-adjusted wages. This trend of lower PSM-adjusted
wages than efficiency wages to bring about a similar rise in effort applies to all 15
countries, even in those that show an inclination for a higher than average PSM-
adjusted wage increase, such as Spain and Bulgaria.
Discussion
This paper attempts to develop a model to explain the complex relationships between
wages, PSM and effort amongst the public sector workforce. The model, which was
piloted on 15 countries, presents four prominent findings. First, many governments
are found to be paying their public sector workforce efficiency wages. Countries that
failed to meet the efficiency wage specification in the public sector are USA,
Denmark, France, Bulgaria and Russia. According to wage efficiency theory,
employees who receive wages that are higher than the prevailing market wages are
likely to be exerting an optimum level of effort. If this is true, then one could expect
the public sector employees in most of the countries studied to put forth high levels of
effort in their work.
Second, the elasticity of PSM with respect to effort, ef, is estimated to be greater
than the elasticity of effort with respect to wages, e. This would suggest that a more
cost-effective way to raise government employees’ effort is through their PSM levels.
The findings confirm the significance of PSM in shaping effort (Alonso and Lewis
2001; Brewer and Selden 1998; Bright 2000; Naff and Crum 1999).
16
Third, the PSM-adjusted wage (ee) is found to be lower than e for all 15 countries.
On average, a 1 per cent change in effort is associated with 0.25 per cent change in
efficiency wages, relative to 0.16 per cent change in PSM-adjusted wages. In short,
when the employees’ PSM is considered, one would require a smaller increase in
wages, or one that is lower than the amount proposed by efficiency wage theory, to
bring about a rise in effort. The finding downplays the significance of wages in
driving effort amongst government employees with high PSM levels, and is supported
by earlier research (Perry and Hondeghem 2008; Perry and Wise 1990).
Fourth, there are some countries which registered unique characteristics. The fact
that the Spanish public sector paid their employees one of the highest wage premiums
(1.22) amongst the 15 countries, but registered one of the highest e value (0.33) might
suggest that the public sector wage level in this country has risen beyond the level
required to achieve an optimum effort level, as discussed earlier in Figure 1. Despite
being paid a large wage premium, Spanish government employees required higher
than average increase in their efficiency wages to bring about a rise in effort similar to
those of their international counterparts. Their PSM-adjusted wage is much smaller
than their efficiency wage at 0.20, though it is still above average. It is likely that
these employees placed a greater importance on wages than their international
counterparts. The variance in the values of e and ee across the 15 countries highlights
the differing emphasis placed on the importance of wages across different countries.
Government employees in Spain and France, for example, required greater changes in
efficiency and PSM-adjusted wages than those in Denmark and USA in order to
change their effort by a similar amount.
17
The results for American government employees are worthy of special mention.
Although they received wages that were lower than those of their private sector
counterparts, they required a comparatively smaller change in wages than that of their
foreign counterparts in order to raise their effort by 1 percent. Although PSM is one of
the contributing factors, this article does not discount the possibility of other factors at
play in affecting effort levels. Further research should consider other factors in the
analysis, such as the work environment (Moynihan and Pandey 2007; Perry 2000),
and job attributes (Grant 2007, 2008; Taylor 2008).
This study is subject to a few caveats. The first relates to the small sample size.
This model was piloted on a small group of full-time public sector employees. The
second involves the use of cross-sectional data, which cannot be subjected to time
series analysis. The third pertains to the reliance on pre-existing survey research data.
This implies that the findings are constrained by the items used to determine PSM.
Future research should be conducted with a larger sample size, across time, and with
stronger and established measures of PSM, notably Perry’s PSM instrument (Coursey
and Pandey 2007; Perry 1996, 1997; Vandenabeele 2008). Nevertheless, the findings
in this small pilot study support the descriptive literature and empirical studies
containing assertions on the significance of PSM in the workplace. In particular, it
suggests that PSM not only reduces the reliance on wages to raise effort, but it also
accounts for a larger change in effort than wages.
18
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23
Table 1 Efficiency wages, elasticity values and PSM-adjusted wages of full-time government employees in selected countries, 2005
Countries Efficiency wage ratio e ef PSM-adjusted wage (ee)
USA (N = 841) 0.62 0.20 0.68 0.15
Canada (N = 471) 1.07 0.21 0.62 0.13
Great Britain (N = 330) 1.09 0.23 0.61 0.14
Denmark (N = 960) 0.83 0.18 0.62 0.11
France (N = 842) 0.88 0.30 0.59 0.18
Germany (N = 660) 1.20 0.31 0.60 0.18
Spain (N = 493) 1.22 0.33 0.63 0.20
Bulgaria (N = 428) 0.85 0.40 0.65 0.27
Slovenia (N = 496) 1.15 0.18 0.60 0.11
Russia (N = 873) 0.78 0.26 0.61 0.16
Israel (N = 415) 1.14 0.27 0.64 0.17
Japan (N = 379) 1.26 0.28 0.58 0.16
Taiwan (N = 1120) 1.17 0.22 0.61 0.13
Australia (N = 832) 1.08 0.21 0.61 0.13
New Zealand (N = 612) 1.03 0.21 0.61 0.13
Average 1.03 0.25 0.62 0.16
e = elasticity of effort
ef = elasticity of PSM
N = number of respondents.
24
Notes
1 The significance of considering relative wages in affecting outcomes is supported by
other scholars. Duesenberry (1949) formulated and econometrically tested the relative
income hypothesis which proposed an asymmetric structure of externalities. Frey
(2008) similarly noted that individuals today are faced with extended possibilities for
social comparisons, which can affect their perceptions of the value of income: ‘It is
not the absolute level of income that matters most, but rather one’s position relative to
other people’ (Frey and Stutzer 2002, p.85). Equity theory also raises the idea of
social comparability, which can be applied to wages. It proposes that individuals
evaluate the ratio of their inputs to outcomes for a given task in relation to a
comparative referent (Adams 1965; Harder 1992; Walster et al. 1978). The optimal
point exists when the individuals perceive the ratio as a balanced one, i.e., equal to
one. At this point, they can focus their energies on achieving the organization’s goals
as this will in turn satisfy their personal goals. On the other hand, employees who
perceive that they are undercompensated or treated unfairly can resort to negative
actions, such as theft, reduced output quality, and turnover (Cowherd and Levine
1992; Greenberg 1990; Summers and Hendrix 1991). In his study of professional
basketball and baseball players, Harder (1992) found that under-rewarded players
behaved less cooperatively and more selfishly.
2 This norm of reciprocity in an exchange relationship, such as that of employment,
has also been raised in the psychological contract literature (Coyle-Shapiro and
Kessler 2003; Rousseau and McLean Parks 1993).
