Tuesday, April 20, 2010

Should wages be determined by the market?

I saw an editorial recently that concluded that it might be better to not let the market determine wages. This article made me see how bad economists are at communicating their most important concepts, in this case market determination. As you will see below (if you are still awake) it makes good sense for the market to determine wages. In future posts we might apply similar points to market determined interest rates, stock prices, profits, and rents.

What market determined wages (MDW) DOES NOT mean. First, MDW are not set by the government. Second, they are not determined by some guy (or gal) named Market. Third, wages are not determined in a big workers’ tent similar to the goods tent where people buy and sell used goods like cuckoo clocks, Depression glass, and Barbie dolls.

MDW means that wages change according to the laws of supply and demand. AHA – says the skeptic – that’s a bunch of bunk. My wage is determined by that creep they call my boss who sits in the big office by the window. It is true. Depending on where you work there is always someone or some committee who tells you your wage. Or maybe you tell them what wage you will accept. “Listen here Fred, unless you guys give me a 10% raise this year, I am going to retire and play third base for the Yankees. “ Maybe your wages are set as a result of a big negotiation between your union and the management.

Let’s call this person/committee/negotiation the One who sends you the Wage News (or THE ONE, for short. Okay? So the relevant question becomes, how does THE ONE decide that you are worth an extra 10% this year? This is where THE MARKET comes in. This is where SUPPLY AND DEMAND comes in.
Let’s suppose you are a website designer and it turns out that a new report forecasts that many companies are going to need new websites next year. You look in the newspaper and there are hundreds of ads for web designers. Wow! Clearly the demand for your services is up and this is the kind of year when you might be able to get a good wage. Your skills haven’t changed a bit but the demand for your services is much higher. That’s an example of the impact that demand has on the labor market and your wage.

What about supply? This is the example that bothers people – especially people who compete with low-to-medium-skilled workers globally. Globalization has increased the number of people globally who compete with you when it comes to producing various kinds of manufactured goods. You continue to be a good citizen and hard worker, but the truth is that labor supply has increased substantially. When there are other workers who really want to work and who are willing to work for a lower wage, this is an example of labor supply increasing. If labor demand does not automatically increase as much as the supply, then the market wages declines.

Summary of the theory of the labor market:
o If labor supply increases and/or labor demand decreases – the market wage rises less than expected or it declines.
o If labor supply decreases or/or labor demand increases – the market wage rises more than expected or increases.

The One Who Sends You the Wage News will usually use this theory of the labor market to determine your wage. If he/she does not, then the organization’s costs are not being managed efficiently – that he/she is wasting the organization’s resources. If THE ONE consistently pays you more than the market values you, then the organization might have been using the surplus payments more wisely. If THE ONE pays you less than the market wage, then the organization has saved money but it will result in less productive employees and probably higher turnover costs. Of course, YOU might be worth more or less than the average wage or you might be married to the boss so The ONE will naturally bring all that into the equation as well. Normally not everyone will receive the exact same wage increase.

Is any of this FAIR? It depends on what you mean by FAIR. A market system’s main goal is to use a nation’s resources as efficiently as possible. That means the system tries to minimize waste. That seems like quite an undertaking. In doing so, it cannot also make sure that every human resource is paid equally. That’s why we have a mixed economic system in which the government attempts to offset the worst income inequalities through taxes and spending. If the government can reduce the worst wage inequities while not creating perverse long-term disincentives, then a mixed system might be able to achieve two goals – near-optimal efficiency and near-optimal income distribution.


  1. Dear LSD. Good ‘splanation. Let me guess, the editorial you read stating the market should not set wages cannot be found at the WSJ.

    I’ve never found applying the law of supply/demand to wages, etc. difficult ‘cause Adam Smith showed me the invisible hand (e.g. you scratch my back and I’ll scratch yours).

    I heard recently that some ‘small’ businesses have said they are not hiring youngsters because the new minimum wage is too expensive. I guess that is an example of that old invisible hand, eh?

    This turn of the worm reminds me of another law, that of unintended consequences. Those ‘small’ businesses’ refusal to hire will increase the unemployment rate, according to the hearsay, mostly for minorities, thus creating yet another social problem the govomit will have to “fix.”

    Interesting that all those wise folks in D.C. don’t know that the law of unintended consequences often shakes the invisible hand of the law of supply and demand.

  2. A clear explanation with all the basics for a solid understanding of MDW and, more generally, market-determined pricing. :) Nice job Lär!
    K. Holschuh
    Karlshochschule International University

  3. Yes Charles the editorial I saw was in the Bloomington Herald Times and not in the WSJ.

  4. The biggest problem with setting compensation for services is that labor is not an undifferentiated commodity. When I started working as a private E1 in the US Army I got paid $US40 a month (as did all the other E1s). True I got room and board, clothing, transportation, and other benefits; but so did all the other guys in the Army. There was a bonus of combat pay when I was competing to get the second place trophy for the SE Asia War Games in 1967, and everyone in country got that. But no one would claim that everyone who got combat pay was equally deserving; or more to the point produced services that contributed equally to the Army's goal.

    To supplement my educational expenses I also drove a cab in Miami over Christmas vacation. The compensation there was completely different. I could drive to the airport and park in storage waiting for a fare and not get paid a cent. I could also turn on the dispatch radio and take calls keeping busy all the time and make much more money.

    At one extreme the Army treated labor as an undifferentiated commodity and paid accordingly; at the other extreme a cab company rented a cab for $US17 a shift and 11 cents a mile and the driver only got paid when a fare was in the cab.

    By leaving out the issue of how to fairly compensate workers with different abilities doing the same job you ignore what to me is the biggest problem employers have in setting wages.

    How would you address the issue of differentiating skill levels (and by implication compensation) of workers performing the same function?

    Not to dis the Yankee's third baseman but do you think he should be paid as much for his services as Calvin Edwin Ripken, Jr.is/was paid to play third base?

  5. Kai -- thanks for the nice comment!

    Mike -- with limited space I try to keep the blog focused as much as possible to what I know -- macro. I was reacting to an article that seemed to think that the market was a bad way to set wages. My mind immediately turned to market-oriented settings. I don't pretend to know how human resource officers and others decide the relative pay of people at different jobs or people at same jobs with different skills. Being optimistic, my hope is that they are objective and try to pull in all the relevant information necessary to form an index of productivity or value added. But being optimistic doesn't preclude all sorts of subjectivity that works into these decisions in both good and bad ways. I will let others use their expertise to decide if Danica Patrick or Tiger Woods should make more money than a high school math teacher.

  6. Hi Larry,

    In one sense the market always sets wages. Remember the term "brain drain" (made some what famous in the movie "Help" when the English scientist complained higher wages and lower taxes in the US forced GB workers to migrate to the US). Today some workers and capital are moving East to seek better working conditions.

    I know some peeps think macro applies more to national than international models. But one of the first things I learned in the military was that less than 10% of the troops do over 90% of the killing. I also found this to be true (if you modify the 10-90 numbers) for much of my working life.

    Many economic theories factor in the idea that "incentives matter", and hopefully HR guys do the same thing. It is one thing to say a factory workers wages should be tied to the number of widgets he produces in an 8 hour shift. It is a completely different matter to set compensation for a bio-chemist like Bob Holton. My locker at the FSU gym was two lockers away from the one assigned to the prez and it was interesting to see how both Sandy, who worked out regularly, and T.K., who did not, addressed the issue of compensation for Bob


    It is one thing to discuss pay levels for current divas, be they golf players or third basemen. It is another to figure out the best way to keep guys like Bob productive. It may not be macro, but economic progress (and progress in general) is much more dependent on compensation for bio-chemists than divas.

  7. I don't think there is an inherent issue with motivating people who work in the services sector. However the application is often where it fails. There is no one example for services since it depends on the kind of service. At Indiana University we have very elaborate annual rituals involving lots of people and information to determine annual pay raises, reappointments, and tenure. In the case of a research institution, research is very important and you can easily see that productive scholars usually are paid better and receive a lot of incentive in non-monetary forms. Some of us grumble about the system at times but overall it works. Consultants, bankers, and other service workers usually find themselves in similar system. If you can somehow count the widgets or other quantitative outcomes of a factory worker, there is no reason in principle why you cannot enumerate and evaluate the productivity of a service worker.

  8. Griping about how much someone else makes (whether they are a Wall Street exec, or the guy in the next cubicle/workstation) helps to identify the small-minded slackers in our economy. And there are sure are a lot of them!

    In a compensation-related matter, I was hoping that Congress would extend the same tax benefits for health care premiums that employers receive to individuals. No dice there of course.

    Instead they offer direct subsidies as incentive (and a penalty as the stick) to attract uninsured individuals into the health-care insurance market. Meanwhile, they completely ignore the millions of self-employed citizens who pay for their health-care insurance without a tax benefit or a subsidy.

    And starting in 2014, they're raising the AGI floor for the deductibility of medical expenses too. So thus creating an incentive to: (1) NOT to be insured via a high-deductible HSA plan, and (2) NOT to go to the doctor until emergencies arise.

    It's as if they designed the whole package to further aggravate the flaws in our current system.

    The bias against the productive in our current government is maddening.

  9. I worry less about peeps griping about wage levels than disincentives which may result in workers not producing as many goods and services as they might. Ignoring the fairly well accepted economic concept that "incentives matter" can have unintended consequences. In the case of HCR the already existing doctor shortage will almost certainly get worse as potential doctors see a likely decreasing income and increasing govt regulation.

    Given the ~$US250k and above income tax increase it is almost certain many doctors will limit their income to $US249k; probably by seeing fewer patients.

    In a way this is getting way off topic, but what do you expect from a 3k page bill that was passed with almost no one reading it. And to make matters worse huge parts of the bill consist of short references to much longer portions of fed regs. If those references were replaced with the full language of regs they refer to the length of the bill might well be an order of magnitude larger.

    Sorry about the off topic rant.

  10. John and Mike -- you guys are focused on income and incentives -- that's fine. We will all be watching how this healthcare bills comes into play. One incentive I can add in the spirit of market-driven wages is incomes of people who help other folks avoid taxes. One can bet that these folks are and will be in greater demand and given some supply inelasticity, their wages should be quite healthy. Who said you can't build a nation with services? :-)

  11. I agree there will be more demand for peeps with knowledge of tax avoidance. The problem I have with this is some goods and services have obvious benefits (see my post about Bob and Taxol above, pun intended)while others like pointing out tax loop holes may have more limited benefits.

    But just as important is the downside of a govt policy that provides bigger incentives to peeps who's offer tax avoidance services as opposed to guys like Bob who offer services and goods that cure cancer.

    Maybe it is because I am a cancer survivor, but to my way of thinking a good government would offer bigger incentives to health care providers than to tax lawyers.

  12. 200 lawyers at the bottom of the sea....:-)