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Higher wages increase labor costs but also improve the productivity of the labor force in several ways. If firms take this into account and set their wages accordingly, the resulting wages could fail to adjust demand and supply but may induce phenomena like over-education, discrimination, regional wage differentials, and a tendency for larger firms to pay higher wages. All these phenomena are quantitatively important and well-established empirically. Efficiency wage theory provides an integrated theoretical explanation rather than a sundry list of reasons, and offers an efficiency argument for progressive income taxation.

We exploit regional differences in labour market density to conduct a simple empirical test of dynamic monopoly and selection wage theories. According to selection wage theories employers offer above-average wages in order to attract more applicants. This allows them to be choosier and to select only the most productive workers. High wage offers reach more potential applicants in densely populated regions and can therefore be expected to be more important there. Observationally similar predictions arise in models of dynamic monopsony. The empirical implication, that firm-size wage effects should be more pronounced in urban labour markets, is tested empirically based on the German employment register data. Our results are in favour of monopsony and selection wage theories.

In der Öffentlichkeit wird oft die These vertreten, daß die zunehmende Ungleichheit der Lohneinkommen ökonomisch geboten, wenn auch gesellschaftspolitisch bedenklich sei. In diesem Beitrag wird gezeigt, daß die Lohnbildung in modernen Arbeitsmärkten nicht dem Prinzip der kompensierenden Differentiale folgt und damit zugleich ungerecht und ineffizient ist. Maßnahmen, die die Lohnspreizung eindämmen, fördern zugleich Effizienz und Gerechtigkeit., In German public discourse it is often argued that the increasing wage inequality we observe is economically required but may be problematic from a social point of view. It is urged here that wage formation in modern labor markets deviates systematically from what the principle of equalizing wage differentials would require. In this sense, it is both inefficient and unfair. Measures that curb wage dispersion increase both efficiency and fairness.

Applicants for any given job are more or less suited to fill it, and the firm will select the best among them. Increasing the wage offer attracts more applicants and makes it possible to raise the hiring standard, thereby improving the productivity of the staff. Wages that optimize on the trade-off between the wage level and the productivity of the workforce are known as selection wages. As men react more strongly to wage differentials than females, the trade-off is more pronounced for men and a profit-maximizing firm will offer a higher wage for men than for women in equilibrium. The argument is not confined to issues of sex discrimination; rather it is of relevance for all labor markets where labor heterogeneity is important and supply elasticities vary systematically across occupations.