Why It Pays to Pay Employees More

(Photo: Peter)

We blogged a while back about how some retail firms succeed by hiring more, not fewer, floor employees, and by treating them particularly well. Among the examples: Trader Joe’s and Whole Foods; among the counterexamples: Michael’s.

This prompted an e-mail from Hal Varian, Google’s chief economist. (If you don’t know of Hal you should, as he’s an impressive and fascinating guy — check out the Q&A he did here a few years back.) His e-mail reads:

Saw your piece about Trader Joe’s et al.  Here’s one reason to pay people more than their market wage (from my textbook):

Gabor Varszegi has made millions by providing high-quality service in his photo developing shops in Budapest. (See Steven Greenhouse, “A New Formula in Hungary: Speed Service and Grow Rich,” New York Times, June 5, 1990, A1.)

Varszegi says that he got his start as a businessman in the mid-sixties by playing bass guitar and managing a rock group. “Back then,” he says, “the only private businessmen in Eastern Europe were rock musicians.” He introduced one-hour film developing to Hungary in 1985; the next best alternative to his one-hour developing shops was the state-run agency that took one month.

Varszegi follows two rules in labor relations: he never hires anyone who worked under Communism, and he pays his workers four times the market wage.  This makes perfect sense in light of the above remarks about monitoring costs: there are very few employees per store and monitoring their behavior is very costly.  If there were only a small penalty to being fired, there would be great temptation to slack off. By paying the workers much more than they could get elsewhere, Varszegi makes it very costly for them to be fired — and reduces his monitoring costs significantly.


Costco pays its people more and offers better benefits. Wegmans has more people and pays better. Market Basket (a NE chain) also has floors crowded with employees. These are highly profitable companies.

Mike B

Paying employees the lowest price the market will bare and not offering benefits that keep them attached to the organization (ie pensions or career tracks with wage and responsibility increases) has accelerated the proliferation of both the disposable worker and the disposable job. This isn't your grandfather's disposable worker where some evil boss uses up the worker's mental and physical health before discarding them to be replaced by some new worker who has no other choice. Instead the relationship is mutual. Employers don't care about the employees and employees don't care about the job. A disposable job is where compensation is so low and the long term prospects so absent that its barely worth the employees time to bother even showing up. The real loser actually turns out to be the consumer who, in their effort to minimize costs, winds up with exactly the service they are paying for, ie bad.

Employers who go after disposable employees aren't necessarily being stupid. If training and replacement costs are low (which they certainly are in this economy) churning through a long string of employees isn't going to erode the bottom line. However, if so much additional success can be had with the higher cost, non-disposable model, why do so few employers embrace it? First of all it requires more management skill. With disposable employees the solution to every problem is to fire the worker and get a new one. With employees that represent an involvement you suddenly have to manage them to protect that investment and get the highest return from it. Second, disposable employees represent less risk to managers living in a Cover Your Ass environment. If they hire a bad apple, under the disposable model they're out the door and the cost is minimal. Under the higher value model not only will the employee have been invested in to a greater extent in terms of training, but also have taken home 4 times the pay.



If the competition really took a month to do the same job, any service at all would have made him rich. Does this example really support your point?


Are these people paid more than the market wage or are they paid the market wage for superior workers?

Erik Dallas

The ultimate case of superior wages is the CEO job, however this seems to be the nepotism of good old boy network and not the use the fear of firing to invoke superior more dedicated performance.
For everyone else and their real earth bound job structure where lack of performance has real consequences: this is the age old problem of Paying for superior quality service or cutting cost to produce the cheapest possible disposable low quality product/service. If you pay nothing and don’t like what you got you can always sample another source to see if another cheap product is any more desirable. What gets interesting is when superior wages invoke superior volume or increase client / customer base such that superior wages incent higher return on investment – i.e. it increases output profit per wage dollar. As noted by others skilled jobs, jobs with a lot of specific job training, or client service jobs where relationship matter, are probably more likely to invoke high replacement cost and thus warrant above market pay as a retention and performance method.



Same goes for In-N-Out Burgers. For fastfood, they pay very well and offer benefits. Their restaurants are always very clean and their employees really friendly :)

Jessica Epp

Does the opposite hold true? Does this mean that in environments where it is extremely difficult to fire employees (unions, situations where you have to prove just cause, etc.) there are few rational reasons to pay an above market wage?
I imagine that in Hungary in the 80's there would be little to no liability risk in firing an employee. The more difficult it becomes to get rid of an unsatisfactory employee, the less this strategy would seem to work.

Fitty Stim

@Jessica Epp: There was no such thing as firing an employee in Hungary (or anywhere in Eastern/Central Europe) in the 80's. We're talking the pinnacle of Rambo Communism here.

Factory workers making vases, trucks loading said vases and driving them to another factory that crushes the ceramic vases into powder, workers loading powder into bags and loading them onto a truck to take to the vase making factory.

But at least the trains ran on time...


A mentor of mine always used to tout: "If you pay'em peanuts, you'll get monkeys"

Malice in Wonderland

I had been hoping for elephants...


This seems kind of obvious to me. You get a dual benefit from paying more: Employees have increased risk of losing a job, but also you get your "pick of the litter" so to speak which presumably means more competent and higher performing employees.

Customer service tends to be a big factor in patronage.

When I was younger I had a friend who worked at a support center, where call in to fix a problem with some hardware or software or computer they just bought. His description of the place was great, it sounded like a great place to work and people actually wanted to work there. He worked there for a few years before starting his own landscaping company. They handled support for some companies that had a reputation which hinged on the support provided. A few years later (about 8) I was hard up for a job and saw they were hiring. It had completely changed.

The place had an average employee retention of something like 2 months. I worked there for 3 months before I was completely spent by the job, and when I quit there was literally only 9 or 10 other people who were hired at the same time I was. I started in a pool of over 30 people in training, and training wasn't cheap. At least I assume it wasn't, because we got paid and it was a week long.

I don't know if they changed because they were facing increasing competition with centers in India (which this company had some recently opened there) or if it was some other motivation. But the change was for the worse, and the products they supported no longer had a reputation for great support. And the most ironic thing, they had this huge presentation about how we were supposed to bend over backwards for the customer, yet the company wasn't even willing to go half as far for the employees.

This, to me, seems to all stem from the modern corporate culture of the short term profits over long term business cultivation. Cutting workforce, QA and employee benefits is great for the next few quarters' reports, but the long term effect often seems disregarded.

It would be great to see a study of long term performance (2 to 5 years) of several companies following sharp layoffs and employee benefit cuts.


Jeff Yablon

Stephen, this is one of those amazing "think different" issues that we can debate forever. For the record, I'm on the "pro" side.

I'll try to give you my experience without going on for too long, or giving away any secrets.

PC-VIP (http://pc-vip.com), our fixed-cost business computer support service for the SMB space, was conceived from day one with exactly this thought in mind. We hire (contractors, but the point is the same regardless) technicians at a rate that's about 2.5 times what the typical independent computer geek makes.

Those folks are loyal. We don't lose them to competitors, and they don't try to steal the clients we assign them to. 'Nuff said.

This idea is very much like the becoming-more-common "unlimited vacation" policies that companies are starting to adopt. Old-school thinkers will believe that this is a recipe for the benefits payer to be abused. Smart business people will see the truth; people with unlimited vacataion work to get their jobs done, not to satisfy a clock, AND (sad but true) tend to take less vacation in protection of their jobs. Oh, and there's no legal/financial issue over unused vacation time.

My company does outsourcing and various types of management consulting, and I can tell you from many years of experience that good management of issues like this are where business change and growth come from. It's nice to see you talking about it out loud.

Jeff Yablon
President & CEO
Virtual VIP Group.



I have seen this strategy in action, sort of. I worked for a major railroad and the pay was fantastic(like it said, make it costly for an employee to get fired or leave) but at a certain point if the management within the company is so terrible it becomes worth the penalty to get a different job. Poor management of employees can become such a drain on morale that you don't even want to go to your very good paying job. I had the misfortune of working for one such manager, and the only way he could make it look(to his superiors) like he was competent was to dicipline employees for actions that were in fact minor. The only effect that this had on our shift was to make us hurry to get our work done so you could be somewhere else when he came in the morning. After 5 years of putting up with this guy it wasnt worth it any more.


Three points:

1) well-paid employees are usually happy and productive employees
2) good word-of-mouth from satisfied customers is the best advertising
3) businesses which view customer service as a cost, rather than an opportunity, are generally not long for this world

Bill Ogorodny

This is a great article. I worked in retai management for organiztions that did not pay their sales help more than minimum wage. These employees did not care if they were fired because they could find other jobs that would pay the same. By paying the employees a decent wage an organization will reduce turnover. So much money is spent hiring new employees and training them


This is an example of the "efficiency wage" concept (http://en.wikipedia.org/wiki/Efficiency_wage) mixed in with some Coasian theory-of-the-firm ideas.

I wonder if more pervasive unemployment insurance undermines this notion.

Frank Pizza

This letter does not prove the point really. A service several hundreds of times faster is going to be popular! Paying the staff well was probably more about the responsibility level being higher in managing such a new business and the need to attract highly capable and business-savy people to work there.

Fitty Stim

This concept might work in Eastern and Central Europe.

But I find it fairly offensive. The basic premise is that employees are going to "slack off", which in itself really means "steal". So in order to prevent the employees from stealing, he pays them a decent salary.

However, the fact remains that he can pay them a high salary and presumably still make a profit (and presumably still pay himself a nice living wage).

So the lesson from this story is that people should be paid living wages. The minimum wage in the US is a joke. Call your senator and demand an increase in the minimum wage to reflect the actual cost of living in the US. Alternatively, one might run around waving one's arms like a chicken with its head cut off. Either one is fine by me...


LIke a previous person said, i believe that if a business can do well, and make a decent living for the owner the owner should share the wealth with his employees. Yes, i do imagine that you could use the money to expand but in my mind the money you could use to expand could be used to make the places you have better. With that said, no matter how much money you pay your employees they still will leave if you can't manage well. I believe that it is a mix of the two that lead to a healthy company and happy employees and customers.


It does make sense that making a larger investment in employees creates a larger payout. True, it does present more of a risk, but all smart investment have risk. This particular investment can be a little more predictable. You know that if you train employees more so, and with a quality education, they will know how to be more productive, and will have the monetary incentive to pursue productivity.