Once upon a time there was a car manufacturer. One day he proposed to double his workers wages. The business community was stunned. Was this man insane? A socialist? Did he not understand the laws of economics? Surely his business would instantly go bankrupt and nothing more would be heard of him. In response he simply pointed out that with a wage increase his workers could now afford to buy the cars they made. Business boomed, profits rose and the company redesigned the entire car industry. The man’s name was Henry Ford.

How could doubling the wages increase profits? To understand it, let me explain the position of Ford in 1914. The assembly line greatly increased productivity but it was extremely boring for the employees. This led to enormous turnover of 370%. In other words if Ford hired 4 workers by the end of the year 3 of them would have quit. Daily absenteeism (employees not showing up for work) was also extremely high with 10% of the workforce not showing up on any given day.

In response to this, Henry Ford cut workers hours from 9 to 8 while doubling their wages from 2.34 to 5 dollars a day. In other words he gave them more pay for less work. Within a year, turnover had shrunk to only 16% and absenteeism was only 2.5%. Worker productivity increased by 40-70% and profits rose by 20%. Although it may sound counter intuitive, doubling wages led to an increase not a decrease in profits. Ford described the plan as “the finest cost cutting plan we ever made.”

This is an example of the Efficiency Wage concept which explains how sometimes it makes sense to pay employees more not less. There are numerous reasons why this is the case. With higher wages the employee has more to lose by being fired and thus will work harder. Higher wages increases morale which increases productivity. Think about it, are you going to work well if you dread going to work or hate your job?

Workers might see their high wages as a gift from the company and work hard to repay it or show they deserve it. High wages make workers less likely to quit which saves the company the cost and effort of hiring and training new workers. High wages also help attract better skilled workers. If you pay the best you get the best, whereas if you pay peanuts you’ll get monkeys.

It is for these reasons that the seemingly common sense idea that cutting wages will cut costs isn’t always true. In fact sometimes the best way to increase profits is to increase wages.

For more on Henry Ford’s 5 dollar day http://www.nber.org/papers/w2101.pdf