We hear it's nice to work there.

Not Everyone Can Work for Costco

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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All right, boys and girls, it’s time to have some real talk about efficiency wages.

I know, you’re older now. You’re starting to notice things that you never noticed before. Like the differences between Costco and Wal-Mart, differences that suddenly seem so ... intriguing. Exciting. You suddenly want to explore those feelings, maybe post a few GIFs to Facebook. You hear other kids talking, and suddenly you wonder about this whole new world of labor relations that you never even knew existed.

I want you to know that what you’re feeling is completely normal. Efficiency wages -- that’s the scientific term, and we’re going to use scientific terms, not that dirty talk about scabs and exploiters that you hear in the locker room -- are very exciting. It’s only natural that you want to explore. Now, stop tittering. I said “explore,” not “exploit.”

But you need to explore safely. You can’t just plunge straight into advocating a $15-an-hour minimum wage; you need to know all the facts so you can make sound, educated decisions about your labor-policy activism. So let’s talk about efficiency wages and how they work.

When an employer loves his workers ... OK, never mind. Straight to the real talk.

Have you heard the legend of Henry Ford’s $5-a-day wage, how he paid his workers enough to buy one of his cars, and thereby unleashed a wave of prosperity upon America, the likes of which the world had never seen? Here’s the truth about that $5 wage: Ford Motor Co. didn’t pay those wages so the workers could afford the cars, because mathematically, that could not possibly have been profitable even if employees actually spent every cent they earned on the product they made. Which they never do.

Ford Motor Co. moved to a high wage because Ford Motor Co. had a turnover problem. Working on an assembly line is a fantastically awful job. Yes, I know it is fashionable to lament the decline of “good manufacturing jobs,” but what was good about those jobs was the steady, high wages. Much of the work Ford offered was unbearably tedious -- tightening the same bolt, over and over, for the majority of your waking hours. It’s about as entertaining as watching paint dry, only with a foreman yelling at you to watch faster, dammit. If hell were designed by industrial engineers, this is what it would look like.

Understandably, turnover was high. And turnover is expensive. You have to train a new person to tighten that bolt and get him used to the rhythm of the line. While he’s learning, he’s slower than other workers and more prone to accidents. The $5-a-day wage may have owed something to Ford’s rather, um, unique ideas about labor relations: It came with strings attached, including having the company’s Socialization Organization pry into your personal life. But mostly, it was about reducing turnover and thereby speeding up the line.

This is what economists call an efficiency wage. Paying workers more than the going market rate for their skill level can bring a lot of benefits to your company. You get lower turnover and, arguably, better on-the-job performance. This springs from four sources:

  1. Paying workers more than other workers in their skill class makes them feel warmly toward you. Humans are hard-wired for reciprocity: When someone gives us something, we feel obligated to give them something in return. So if you treat your employees extra-well, they feel obligated to treat you extra-well.
  2. Workers know that if they lose this job, they are likely to end up with a job that pays less. They are thus highly motivated to keep this job.
  3. Employers get to be choosier about who they hire.
  4. The wage attracts people with better skills.

As you can see, this concept is very exciting. But that excitement can get out of control; it frequently leads hot-blooded young progressives to conclude that if we just paid everyone more, all the companies would be more profitable! This is folk wisdom akin to believing that everyone should buy a lottery ticket because your cousin won $1 million that day.

Here’s what they are missing: Efficiency wages only work because the workers are getting more than they could make elsewhere. If everyone was paying the same wages, all the benefits to the employer would disappear.

To see what I mean, imagine if we could go back to 1913, the year before the $5-a-day revolution, and we offer those workers a chance to work for $8.50 an hour at Wal-Mart, 40 hours a week. Adjusted for inflation, that would be a 25 percent raise, a shorter workweek, and instead of tightening a bolt for nine hours in a dark and dangerous auto plant, they’d get to spend their time walking around a nice, air-conditioned, well-lit store. And the chance to buy health insurance!

You might well be able to skim the cream of the crop from Ford’s workforce with such an offer. Those men might be so intensely grateful for the opportunity to be inside, in a comfortable climate-controlled environment, that they’d work their butts off to be employee of the year, every year. You would obviously not have the same impact if you made the same offer today. You’d get, well, the folks who are working for Wal-Mart right now.

The point is not that Wal-Mart employees should be grateful for what they’re paid; the point is that an efficiency wage is determined by the overall wage level in the marketplace. A wage is generous or stingy not by some naturally ordained scale, but in comparison to your alternatives.

That’s one reason why labor agreements in the 1950s through 1970s emphasized compensation arrangements -- such as pensions and seniority raises -- that made it costly to switch firms. Turnover was still a problem for manufacturers even when they were paying higher wages than ever, because some people just can’t hack the monotony of an assembly line. So they gladly acquiesced to pay structures that rewarded longevity. Eventually all that back-loaded compensation became a huge problem for manufacturers, as their markets and their workforces shrank and their legacy costs rendered them uncompetitive. But at the time, it made sense, because with the general wage level high, they could no longer rely on the efficiency-wage effect to deliver a more reliable workforce.

In other words: A strategy of paying efficiency wages to attract, and retain, a higher-quality labor force is by definition a business model that cannot be followed by everyone in the market. If all the employers of minimum-wage labor followed Costco’s lead and paid higher wages and benefits, Costco would be less profitable, because the quality of its labor force would revert to the mean. And Costco’s loss would not necessarily be a gain to any other employer; they’d be paying higher wages but still enjoying the same average workforce quality. Of course, they might attract better-skilled workers from other industries, which could raise productivity. But that’s not a good progressive argument for efficiency wages, because what happens to the workers who used to have those jobs?

When you’ve got some laudable goal in mind, it’s easy to forget that you really can have too much of a good thing. If the Kennedy tax cuts were a good idea, then we should just keep cutting to zero and really unleash some economic growth. If you liked an $8-an-hour minimum wage, why not $15? Why not $25? If it works for Costco, why not for every retailer in the country? Analysts end up acting like teenage boys with a can of Axe body spray: If some is good, more must be even better.

But even good things have natural stopping points, and efficiency wages are one of them. Costco indeed shows that it is possible to pay wages like Costco's -- if you are running a Costco. It does not follow that every company could profitably do the same. In fact, it demonstrates that they couldn’t.

Does that mean that you shouldn’t advocate for higher wages? No; you can make an argument that companies should pay higher wages, and just too bad for the shareholders and consumers who have to take a haircut. I don’t necessarily agree with that argument, but it isn’t undercut by efficiency-wage theory.

But it does mean that you can’t argue for such raises from the behavior of Costco and other companies that follow an efficiency-wage strategy. If you’re going to advocate for higher wages, do so safely, responsibly and with all the facts.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Megan McArdle at mmcardle3@bloomberg.net

To contact the editor on this story:
Brooke Sample at bsample1@bloomberg.net