Effects of Wages and Working Conditions on Productivity

The supply-and-demand approach as we have seen it here assumes that the marginal productivity curve remains unchanged as wages and working conditions change. But there is some evidence that a change in wages or working conditions can shift the marginal productivity curve upward or downward, changing the relationship between the number of units of labor employed and the marginal productivity of labor. In particular, a cut in wages may shift the marginal (and average) productivity downward.

In very poor countries, lower wages may lead to reduced nutrition and worse health for the employees, and thus to lower productivity.
In richer countries, a wage above the employee's alternative (that is, above the supply curve) can limit the turnover of the work force. Turnover is costly in itself, and with less turnover the employees have more opportunity to learn to work well together, increasing productivity.
Wages above the supply curve can also increase the incentive to work hard and to "work smart." If wages are only on the supply curve, then the worker has less to lose if she or he is dismissed on grounds of not working hard enough.
The perceived fairness of a wage above the supply curve may also make the employees more willing to work hard and to "work smart."

Now, suppose that an employer cuts the wages (starting above the supply curve of labor) in the hope of cutting overall costs and so increasing profits. Let's call that the direct cost effect. At the same time, the lower wages shift the marginal and average productivity downward. This increases costs, offsetting the wage cut. Let's call that the productivity effect. Profits may either increase or decrease, depending on whether the direct cost effect is bigger than the productivity effect. Some economists argue as follows: when wages are very high, the direct cost effect will be greater than the productivity effect; but as wages drop the productivity effect will increase and the direct cost effect will decline, so that there is a particular wage (above the supply curve of labor) that gives maximum profits. This is called the "efficiency wage."

If market wages are often efficiency wages, then labor markets could behave quite differently than the John Bates Clark supply and demand approach suggests. But what is the evidence?