On 5th January 1914 the Ford Motor company announced that it would more than double the wages of its workers. Briefly describe the history of this decision and relate to the theory of incentives and efficiency wages.

When Henry Ford introduced the five-dollar day on the 12th of January 1914, many of his competitors might have questioned the success of this policy. Today, it is well established that Ford’s strategy was a key reason for the company’s early success and is often documented as an exemplary application of the efficiency-wage theory. This essay will briefly outline the history and implications that have led to the five-dollar day and relate it to the theory of incentives and efficiency wages.
Henry Ford founded the Ford Motor Company in 1903. During the first few years the company remained relatively small and it was only with the introduction of the T-Model in 1908 and the transformation to assembly line production that Ford could expand his market share and increase the company’s profitability.
However, as Raff and Summers noted, assembly line production resulted in a high degree of specialisation of the different production steps. Work at Ford’s became more and more menial, leading to dissatisfaction among the workforce, which reflected in a significant annual turnover of 370% in 1913.
Although there was no evidence that Ford had problems filling his vacancies, the absenteeism and high turnover undoubtedly resulted in costs that Ford had aimed to reduce. It is, however, disputed whether reducing turnover and absenteeism were the main motives in introducing the five-dollar day. Raff and Summers highlight that Ford might have been influenced by his friend Percival Perry, who successfully doubled the wage rate before Ford, or that he was driven by personal motives. Jason Taylor, on the contrary, argues that Ford was primarily motivated by the high-wage doctrine which he continued to follow after 1914 throughout the 1920s and 1930s. However, a detailed analysis of Ford’s motives lies beyond the scope of this essay.
The efficiency wage theory rests upon the assumption that paying a wage above market rate will be beneficial to the company. This is achieved mainly through the following four mechanisms.
The shirking model analysed by Shapiro and Stiglitz is based upon the assumption that a higher wage rate will discourage shirking among workers. Workers usually have some discretion regarding their productivity and therefore tend to reduce effort to maximise their personal utility. Given full employment and equal pay among firms in the same industry, a worker has little to lose when caught shirking because he will be rehired immediately. Firms can overcome this problem by paying a wage above market equilibrium, which will increase the cost of being fired. Even if all other firms follow and pay an equally high wage, the cost of being caught increases because the going wage rate lies above equilibrium, resulting in a positive unemployment rate. While it is impossible to compare or analyse the amount of shirking at Ford Motor Company before and after the wage increase, it most likely contributed to the observed efficiency increment. Figures suggest that, between 1913 and 1914, productivity rose by about 30%.
The turnover model outlined by Salop is similar to the shirking model. Employees receiving a higher pay or facing above clearing rates of involuntary unemployment are less likely resign. The figures illustrating the effect that the wage increase had on Ford Motor Company’s turnover vary, but all of them indicate a significant decrease in the turnover rate. Schlichter’s figures suggest that turnover fell from 370% to 54% for the calendar year 1913 to 1914. Although it can be argued that costs related to turnover at Ford’s were low due to the limited time and training necessary to fully master the tasks, a reduction in turnover of such magnitude undoubtedly decreased costs. Furthermore, absenteeism was reduced from 10% in October 1913 to merely 2.5% one year later, contributing positively to productivity.
In the adverse selection model proposed by Malcomson, the reservation wage increases with the employee’s ability. Firms charging a higher wage will therefore be able to attract workers with a higher ability. Offering a wage rate above the clearing rate will also lead to excess supply of labour that will allow the company to select their workforce. However, evidence suggests that attracting skilled workers was not a main priority for Ford, himself noting that: “We do not have to search for skilled employees. The skill is in the machine.” Given the menial work at the assembly line, an increase in ability would most likely have had a very limited effect on production output.
The sociological models related to the efficiency wage theory mainly rest on the gift-exchange model, outlined by Akerlof, and the fair wage-effort hypothesis described by Akerlof and Yellen. Both theories suggest that an increase in wage will lead to an increase in efficiency. In the gift-exchange model, supra competitive wages will be seen as a gift by workers in exchange for which they increase effort. In the fair wage-effort hypothesis, workers establish a notion of what is a fair wage and will reduce effort in case their wage falls below it. Similar to shirking, the extent to which sociological models have contributed to the increase of efficiency at Ford Motor Company cannot be quantified. It should, however, be noted that Ford laid emphasis on calling the wage increase a profit-sharing scheme which could hint at a gift-exchange mechanism.
In conclusion, it can be stated that Henry Ford’s five-dollar day resulted in a substantial increase in productivity and reduced costs through what nowadays is known as the efficiency wage theory. By paying supra competitive wages, turnover was reduced, while efficiency was increased through discouraging shirking and encouraging greater effort. Solely, the model of adverse selection in efficiency wage theory finds only limited applications to explain the success of Ford’s profit sharing scheme. Finally, while the five-dollar day seems to be an exemplary application of efficiency wage theory, one should bear in mind that Henry Ford’s main motives might have been of a different nature.