In a free market economy, the firm is constantly influenced by the wider market in which it operates. The product market reveals information critical to a firm’s survival, such as what not to produce – when the sale price for a product will not cover the cost of its production; the factor market informs the cost of substitution between factors of production. While there is some room for price-seeking, firms cannot greatly alter the market price for their inputs. To increase its chance of survival, a firm can innovate and supply new and better products to consumers, or it can improve efficiency and produce the same goods at a lower cost than its competitors. Thus, market competition allows profitable firms to grow and causes unprofitable ones to wither, forcing them to produce something different.
At the same time, firms in a market economy adjust the wages paid to their employees in accord with their productivity; employees will lose their jobs if performance is unsatisfactory. This gives firms a powerful incentive with with to motivate their employees, whose productivity, unlike that of other factors of production, is open to the influence of the rate of compensation.
DBx: One of the more bizarre justifications sometimes used for minimum-wage legislation is the so-called “efficiency-wage” theory – which says, in summary, that by paying a worker more than is minimally necessary to retain that worker, the employer brings forth from the worker such a large increase in effort that the worker’s greater productivity more than pays for the higher wage cost. I’ve no doubt that this efficiency-wage effect operates often in markets. But in addition to the often-noted reality that firms do not need to be prodded by legislators to seize such profitable opportunities to use efficiency-wage wages, the very existence of minimum wages, by removing from employers the ability of each to use efficiency-wage wages as each sees fit, eliminates the efficiency-increasing advantages of efficiency-wage wage setting.