Always Higher Wages? Efficiency Wage Theory at Wal-Mart

My dissertation thirty years ago used efficiency wage theory, so I’m always interested when it pops up on the radar again.  According to today’s New York Times, Wal-Mart has apparently made a U-turn in its management philosophy, going from a labor-cost minimizing strategy to one that emphasizes internal labor markets.  More training, more predictability in scheduling and tenure, and climbable job ladders—this is the key, they hope, to reversing a long-term deterioration in performance.

Any blue-blooded social democrat wants to cheer them on and urge them to go even further.  The article clearly takes this view and asks whether an efficiency wage approach, one that sees workers as assets and builds relationships with them rather than just squeezing work out at the lowest possible cost, could address national problems of income inequality, slow growth and productivity stagnation.

I too am a fan of making work more rewarding and meaningful and enhancing the role of workers in enterprises, but I think there are system-level factors that affect how the efficiency wage mechanism operates at the enterprise level—factors the article ignores when it turns to Wal-Mart’s share price as the arbiter of success near the end.

The motivational factor of treating workers well is certainly important, but its effect on overall performance depends on the importance of local and tacit knowledge in the production process.  If workers know details about the firm’s operations from actually being on the front lines and having a hands-on relationship with the work, the firm can benefit from the initiative they take in solving problems as they arise.  No directives from the front office can substitute for that.  In effect, Hayek’s knowledge problem, which he envisioned at the level of an entire economy, also exists at the level of a firm.

At the same time, the argument against Hayek, that system-level aspects have to be taken into consideration as well, also applies to the firm.  The firm’s financial situation, the impact of its competitors and other matters probably beyond the purview of front-line workers also have to be acknowledged.  And especially, the effectiveness of an organization is more than the sum of the effectiveness of its parts; synergy and coherence of strategy are crucial.  Thus every enterprise faces a tradeoff between decentralized initiative on the one hand and centralized “herding” on the other.  You’ll find a schematic of this dilemma in Stafford Beer’s Viable System Model.

Finding a sensible balance is difficult, something firms can do only through trial and error.  But my argument here is that the general location of the balance depends on systemic factors beyond the control of an individual enterprise.  For instance, a country’s education and training system affects the availability of different types of labor and plays a large role in determining the return to internal training and job ladders.  Since there will be movement of workers into and out of individual firms, the payoff to investment in labor depends on whether there are industry- or economy-wide institutions that overcome the resulting collective action problem.  Culture, the prevalent attitudes toward different types of work and the people who do them, affects work organization.  Above all, what constitutes performance in the first place depends on where the economy lies in the shareholder-stakeholder spectrum.

This is because the value of worker commitment and initiative depends on the extent of alignment between what workers think success means and what those running the firm think it means.  Inevitably, workers lean in a stakeholder direction.  For one thing, they are stakeholders themselves.  One aspect of success from a worker point of view is a more meaningful and less onerous work process.  Some of that might be monetizable (turned into profit), but not all of it.  In addition, because they are on the front line, workers interact directly with other stakeholders, like customers or clients and those who experience the firm’s impact on the environment.  Given enough autonomy, retail workers are likely to want to make customers happy and not just get them to spend more, and they are likely to spend time on work that improves the environment inside and outside of the store whether or not it shows up on the bottom line.

In economic terms, the difference between a purely shareholder and a purely stakeholder orientation is that the first seeks to maximize expected profits, the second the likelihood of being profitable.  This is about means and ends: profit under the first approach is the end, with everything else serving as a means, and it’s the reverse under the second.  In the real world we see hybrids, but it’s well known that the US lies well to the shareholder side compared to other capitalist countries, and has tilted even further that way in recent decades.

From this perspective, the critical moment in the Times story comes near the end, when we read

The profit landscape is less sunny. Operating income for Walmart’s United States stores was down 6 percent in the most recent quarter, reflecting higher labor costs and other new investments. The company’s stock has underperformed the overall United States stock market and an index of major retailers since the program was announced, suggesting investors are not convinced that these investments will pay a lucrative return anytime soon.

As long as that’s the determining question, and in the absence of major social initiatives to support a worker-oriented economy, efficiency wage strategies alone will produce only marginal gains.