How do efficiency wages affect employment levels?

Efficiency wages refer to the practice of paying workers a wage higher than the market equilibrium wage in order to increase productivity, reduce turnover, and attract higher-quality job applicants. The reasoning behind this strategy is that when employees feel they are compensated well above their alternatives, they may be more motivated to work harder, less likely to quit, and more inclined to perform at higher levels.

When firms adopt efficiency wages, they often do not hire workers at the market-clearing wage. Instead, they maintain a higher wage even when it creates a gap between demand for and supply of labor. This can lead to a situation where there are more workers seeking jobs than there are available positions, which indeed may result in increased unemployment levels.

Higher wages may attract more applicants than positions available, and when a firm doesn't hire to fill all potential roles due to the elevated wage costs, the remaining individuals are left unemployed. Therefore, the practice of using efficiency wages can create inefficiencies within the labor market, potentially leading to higher unemployment levels as firms have less flexibility in hiring due to their wage commitments.

This explanation clarifies why the effect of efficiency wages can lead to increased unemployment as firms seek to boost productivity and reduce turnover, yet in doing so limit their hiring capacity.