1. Chapter 15 Wage Determination
In this chapter we examine how wages are determined in competitive markets and imperfectly competitive markets. We look at factors that impact wages, including the influence of unions. We will analyze wage differences with union models including craft unions and industrial unions. We will discuss reasons for wage differentials across jobs and analyze the effects of the minimum wage on the labor market.
Wage Determination
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2. Labor, Wages, and Earnings
Price paid for labor
Direct pay plus fringe benefits
Wage rate
Nominal wage
Real wage
General level of wages
The term “labor” is used to refer to virtually any type of worker: blue-collar, white-collar, hourly, salaried, professional, etc. Wages, the price paid for labor, include not only direct money payments but also fringe benefits like vacations and health insurance. A nominal wage is the amount of money received per hour, day, or year. A real wage is the quantity of goods and services a worker can obtain with nominal wages or the “purchasing power” of nominal wages. Wage rates differ greatly among nations, regions, occupations, and individuals.
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3. Global Perspective
The data shown here indicate that hourly compensation in the United States is not as high as in some European countries but is higher than other nations. Generally speaking, the level of real wages in the United States is relatively high as in most other industrially advanced economies. In those nations, the demand for labor is relatively large compared to the supply of labor.
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4. Role of Productivity Labor demand depends on productivity
U.S. labor is highly productive
Plentiful capital
Access to abundant natural resources
Advanced technology
Labor quality
Other factors
The demand for labor, like other resources, depends on its productivity. The greater the productivity of labor, the greater is the demand for it. And if the supply of labor is relatively fixed, that means the average level of real wages will be higher. The U.S. and other advanced economies benefit from highly productive labor. This is due to the plentiful capital available in these nations, access to abundant natural resources, advanced technology, the quality of the labor, and other less obvious factors such as a social and political environment that emphasizes production and productivity.
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5. Real Wages and Productivity
Long-run trend of real wages in the U.S.
S2020
S2000
S1900
S1950
Real Wage Rate (Dollars)
The long-run trend of average real wages in the U.S. has been to increase, in spite of increases in the labor force. This figure demonstrates the trend in the supply and demand of labor since 1900.
D2020
D2000
D1950
D1900
Quantity of Labor
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6. Real Wages and Productivity
This graph illustrates productivity and real hourly wages from 1960 – 2011.
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7. Competitive Labor Market
Market demand for labor
Sum of firm demand
Example: carpenters
Market supply for labor
Upward sloping
Competition among industries
Labor market equilibrium
MRP = MRC rule
Because wage rates vary greatly by occupation, it is useful to look at the factors that determine the wage rate paid for a specific type of labor under different conditions. We begin by examining labor supply and demand in a purely competitive labor market. The market demand for labor is determined by the horizontal sum of the labor demand curves of the individual firms.
The market supply for labor is illustrated by an upward-sloping supply curve, indicating that employers must pay higher wage rates to obtain more workers. The labor market equilibrium is determined by the intersection of the market labor demand curve and the market labor supply curve.
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8. Competitive Labor Market
Wage Rate (Dollars)
Labor Market
Quantity of Labor
Wage Rate (Dollars)
Individual Firm
Quantity of Labor a S e b
($10) WC
s=MRC
($10) WC
D=MRP
(∑ mrp’s)
These graphs demonstrate the labor supply and labor demand in a purely competitive labor market and a single competitive firm. In an individual firm, the labor supply curve is represented by a horizontal line because it is perfectly elastic. The labor demand curve for the individual firm is downward sloping reflecting the fact that to attract more workers, the firm must pay more. The firm will maximize profits by hiring workers up to where MRP = MRC.
d=mrp c QC qC
(1000)
(5)
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9. Monopsony Model Employer has buying power Characteristics Single buyer
Labor immobile
Firm is a “wage maker”
Upsloping labor supply to firm
MRC higher than wage rate
Equilibrium
In a monopsony market, there is only one buyer for labor. The workers who provide the type of labor needed have few employment options other than working for the monopsony, maybe because they are geographically immobile or their skills are not transferable to other jobs. This makes the firm a “wage maker,” meaning that the wage rate it must pay varies directly with the number of workers available. In this case, the firm’s labor supply curve will be upward sloping and the MRC will be higher than the wage rate. To maximize profit, the monopsonist will employ the quantity of labor at which MRC and MRP are equal.
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10. Monopsony Model Examples of monopsony power Wage Rate (Dollars)
MRC S b
Wage Rate (Dollars) a Wc Wm c
In this graph of the monopsony labor market, the upsloping labor supply curve of the monopsonist is shown. MRC, the labor supply curve of the monopsonist, lies above the labor supply curve of the competitive market. The monopsonist will hire Qm workers and only pays wage rate Wm, as compared to the competitive wage Wc.
MRP Qm Qc
Quantity of Labor
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11. Monopsony Power Maximize profit by hiring smaller number of workers
Examples of monopsony power
Nurses
Professional Athletes
Teachers
Three union models
The monopsonist will maximize profits by employing a smaller number of workers and paying a lower wage than the competitive market. Society will obtain a smaller output and workers receive a wage rate that is less than their marginal revenue product. While monopsonistic labor markets are uncommon in the United States, there are a few examples. In the medical area, nurses are typically limited in their choice of employers to the relatively small number of hospitals that may be in their area. Likewise, professional athletes are limited through player drafts to specific employers only. In some situations, labor market workers unionize and create their own monopsonistic power.
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12. Demand Enhancement Model
Union model
Increase demand for union labor by
altering price of other inputs S
Increase
In Demand
Wage Rate (Dollars) Wu
Unions have a limited ability to influence the demand for labor. However, an increase in the demand for union labor will create a higher union wage along with more jobs. In this graph, we can see the effect of an increase in the demand for labor on the wage rate. Wc D2 D1 Qc Qu
Quantity of Labor
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13. Craft Union Model Effectively reduce supply of labor
Restrict immigration
Reduce child labor
Compulsory retirement
Shorter workweek
Exclusive unionism
Occupational licensing
Some unions attempt to restrict the supply of labor available and thus affect the wage rate paid. Labor unions have supported legislation that has restricted immigration, reduced child labor, encouraged compulsory retirements, and created a shorter workweek. Craft unions especially tend to control the supply of labor by requiring workers to belong to the union in order to obtain certain jobs. They may force employers to agree to hire only craft union members. The craft union then maintains restrictive membership policies to control the labor supply. A similar situation exists in many professional occupations which may push for legislation requiring occupational licensing as a way to control the supply of labor.
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14. Craft Union Model Wage Rate (Dollars) Quantity of Labor S2 S1 Wu
Decrease
In Supply Wc
As craft unions decrease the supply of labor, the wage rate increases. The number of workers employed will also decrease. D Qu Qc
Quantity of Labor
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15. Industrial Union Model
Inclusive unionism
Auto and steel workers S a b
Wage Rate (Dollars) Wu e Wc
Most unions seek to organize all available workers, rather than just a select few. Industrial unions seek all available unskilled, semiskilled, and skilled workers in an industry. By including such a large amount of workers, the union can put the firm under great pressure to agree to its wage demands, especially due to its legal right to strike. By agreeing to the union’s wage demand, the firm becomes a wage taker. The labor supply becomes perfectly elastic, creating a higher wage rate but again, reducing the number of workers employed. D Qu Qc Qe
Quantity of Labor
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16. Wage Increases and Job Loss
Are unions successful?
Wages 15% higher on average
Consequences:
Higher unemployment
Restricted ability to demand higher wages
There is much debate as to whether or not labor unions have been successful at raising the wages of their members. Some evidence suggests that union wages are on average 15% higher than the wages of non-union workers. However, both exclusive and inclusive unionism tends to reduce employment in unionized firms. This decline in employment has the effect of restricting the ability of the union to demand higher wages. Workers will balk against wage rate requests so high that many workers might lose jobs.
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17. Bilateral Monopoly Model
Monopsony and inclusive unionism
Single buyer and seller
Not uncommon
Indeterminate outcome
Desirability
Bilateral monopolies occur when there is a strong industrial union in a monopsonist labor market. In this case, there is both a single buyer and seller of labor. The effect on the wage rate is indeterminate since it will depend on which party has the greater bargaining power.
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18. Bilateral Monopoly Model
MRC S Wu
Wage Rate (Dollars) a Wc
In the graph of the bilateral monopoly labor market, we can see the different forces at work. Which force wins out cannot be predicted by economic theory. This situation may be more economically desirable as the most likely outcome is a higher wage rate than under pure competition but more workers are employed than under monopsonistic conditions. Wm
D=MRP
Qu=Qm Qc
Quantity of Labor
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19. The Minimum Wage Controversy
Case against minimum wage
Case for minimum wage
State and locally set rates
Evidence and conclusions
Since the passage of the Fair Labor Standards Act in 1938, the United States has had a federal minimum wage designed to ensure workers earn at least an amount sufficient to support themselves and their families at a basic subsistence level. Some states have passed minimum wage laws of their own with a higher rate than the federal minimum rate. The federal minimum wage was most recently raised to $7.25 per hour (July 2009). Critics argue that the minimum wage, if it is above the equilibrium wage rate, will cause employers to hire fewer workers and may even force some firms out of business since they cannot afford to pay the higher rate. They also argue that many of the workers who receive this minimum rate, such as teenagers, do not actually live in impoverished households and are not self-supporting so do not need a guaranteed minimum.
Advocates of minimum wage argue that in many low-pay labor markets, employers exercise monopsonistic power and thus a required minimum wage can increase wage rates without causing significant unemployment.
There is no clear answer as to which view is correct. On the one hand, the employment and unemployment effects of the minimum wage do not appear to be as great as many critics fear. On the other hand, the minimum wage is not as strong an antipoverty tool as supporters contend since a large part of its effect is dissipated on nonpoverty families.
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20. Wage Differentials
Hourly wage rates and annual salaries differ greatly among occupations. This table lists average annual salaries for a number of different occupations to illustrate such occupational wage differentials.
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21. Wage Differentials (a) (b) (c) (d) W W Wa Wb Qa Q Qb Q W W Wc Wd LO7Sb Wa
(a)
(b) Da Wb Db Qa Q Qb Q
The wage differential between labor markets (a) and (b) above results solely from differences in labor demand. In labor markets (c) and (d) above, differences in labor supply are the sole cause of the wage differential. W W Sc
(c) Wc
(d) Sd Wd Dc Dd
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22. Wage Differentials Differences across occupations
What explains wage differentials?
Marginal revenue productivity
Noncompeting groups
Ability
Education and training
Compensating differences
Wages differentials are created by many different forces and can arise from either the supply or the demand side of the labor market. Even across one occupation, wage differentials can occur. For example, a surgeon just starting out would expect to make much less than one who has many years of experience. If we focus on the affect of the labor demand on the wage differential, we can see that the strength of the labor demand varies greatly among occupations due to differences in how much various occupational groups contribute to the revenue of their respective employers. The marginal revenue productivity of these types of workers is high. We can see this illustrated in the demand for professional athletes. On the supply side, workers differ greatly in their mental and physical characteristics and in their education and training. In some groups, there may be fewer qualified workers than in other groups, leading to higher wages rates for those limited workers. Compensating differences are paid to compensate for nonmonetary differences in various jobs. Undesirable jobs must pay higher wages to recruit workers who could just as easily qualify for less demanding positions.
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23. Wage Differentials
Education can be a significant source of wage differentials, as illustrated in this figure. Investment in education yields a return in the form of earnings differences enjoyed over one’s work life.
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24. Wage Differentials Workers prevented from moving to higher paying jobs
Market imperfections
Lack of job information
Geographic immobility
Unions and government restraints
Discrimination
Why don’t workers just move from lower-paying jobs to higher-paying jobs? Several reasons can be the cause. Frequently there are market imperfections at work. Workers may not be aware that there are higher-paying jobs for which they qualify. They may not be able to move to locations where higher-paying jobs exist because they do not want to leave their families or friends. Unions and other government restraints may also artificially reinforce wage differentials. And in spite of legislation to the contrary, discrimination in the workforce still results in lower wages frequently being paid to women and minority groups.
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25. Pay for Performance The principal-agent problem Incentive pay plan
Piece rates
Commissions or royalties
Bonuses, stock options, and profit sharing
Efficiency wages
Negative side-effects
Pay schemes are typically much more complex than just a fixed hourly rate. Employers may use worker pay to encourage a desired level of performance from workers. In the principal-agent problem, the interests of workers and firms are not identical, resulting in situations where workers seek to increase their utility by working less than agreed upon. To prevent this, many firms employ incentive pay plans whereby worker compensation is tied to worker output or performance. This may be accomplished in several ways. Piece rates compensate employees according to the number of units of output a worker produces. Commission or royalties tie compensation to the value of sales. Bonuses, stock options and profit-sharing plans tie compensation to the profitability of the firm, and efficiency wages seek to enhance worker efficiency or basically encourage workers to work harder.
Pay for performance plans do have their negative side-effects. Piece rates may encourage rapid production at the expense of product quality. Commissions, bonuses, stock option and profit-sharing plans can all lead to encouraging unethical behavior among employees in order to increase their own personal income at the expense of the firm.
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26. Are CEOs Overpaid? U.S. CEO salaries relatively high
Good decisions enhance productivity
Limited supply, high MRP
Incentive to raise productivity at all levels
High salary bias by board members
Unsettled issue
Much attention has been paid in recent years to the amount of compensation received by the CEOs of U.S. firms. In many cases, the compensation of these CEOs vastly exceeds the amounts paid to other workers. Defenders of the system argue that the high pay is justified by the direct or indirect marginal-revenue contributions of CEOs. Critics say the multi-million-dollar CEO pay bears little relationship to marginal revenue productivity and is unfair to ordinary stockholders. This issue continues to be unsettled between the two sides.