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.