Do Higher Wages Pay for Themselves : An Intra-Firm Test of the Effect of Wages on Employee Performance

This study uses field data from 490 hotels in a single lodging chain to investigate three questions related to the efficiency-wage hypothesis. (1) Does paying workers higher relative wages ex ante result in better ex post actual performance, either by motivating workers to exert greater effort or by attracting higher quality workers? (2) Is the magnitude of the relation between performance and wages the same when workers are overpaid versus underpaid? (3) Do the overall benefits of paying higher wages outweigh the costs? The data enable us to perform powerful tests of wage-performance relations because exogenous factors that likely affect employee behavior are standardized across hotels. Our results suggest that actual performance (measured by customer satisfaction, revenues, and profit) is increasing in the relative wage, and that higher performance is the result, and not the cause, of higher wages. We find that the magnitude of the wage-performance relation is at least as large for workers who are overpaid compared to those who are underpaid. This result, which differs from the results of experimental studies, suggests that overpaid workers do not rationalize away wage premiums. Finally, our results indicate that increases in wages do, in fact, pay for themselves. A $1,000 increase in the general manager's relative wage results in a $1,080 increase in profit for the mean hotel. This research contributes to a series of studies that investigates the extent to which wages influence performance (e.g. Levine 1992; Fehr and Falk 1999; Hannan, Kagal, and Moser 2002; Hannan 2005), and whether the marginal benefit of wage increases justifies their costs (Levin 1993)