Chapter 13
Wage
Determination
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
• Labor productivity and real
compensation
• Wage and employment
determination
• Competitive and monopsony
markets
• Unions and wage rates
• Causes of wage differentials
• “Pay-for-Performance” plans
13-2
Labor Wages and Earnings
• Wages refer to the price paid for
labor
– Labor may be workers such as
blue-collar and white collar workers
– Workers may also be professional
people and owners of small
businesses since they provide their
own labor services in operating
their business
• Wages may also be in the form of
bonuses, royalities, commisions
and salaries
• In this chapter, the term wages is
used to mean the wage rate or
price paid per unit of labor time
13-3
Labor Wages and Earnings
• There is an important distinction between
nominal and real wages
• Nominal wages are the amount of money
received per hour (or day, etc), however real
wages are the purchasing power of the wage
– For example, if nominal wages rise by 10% and
there is a 5% inflation rate, then the real wage
rose by only by 5%
– In our discussions, it is assumed that the price
level is constant (no inflation) and the term
“wages” refers to “real wages”
Level of Wages Across Nations
Hourly Wages of Production Workers
Hourly Pay in U.S. Dollars, 2006
0
5
10
15
20
25
30
35
Germany
Sweden
Switzerland
United Kingdom
Australia
Canada
Italy
France
United States
Japan
Spain
Korea
Taiwan
Mexico
Source: U.S. Bureau of Labor Statistics, 2006
13-5
Role of Productivity
• Productivity is very important in
determining wages
• Historically, American wages
have been high and have risen
because of high productivity
• There are several reasons for
the high productivity
– Capital equipment per worker is
high
– Natural resources have been
abundant relative to the labor force
– Technological advances have
been generally higher in the U.S.
than in most other nations
13-6
Role of Productivity
• The quality of American labor has been
high because of good education, health,
and work attitudes
• Other reasons include good management,
stable social and political environment, the
large size of the domestic market, and
increased specialization of global
production enhanced by free-trade
agreements
Real Wages
• Long run trend of average real
wages in the U.S.
Real Wage Rate (Dollars)
–Variation across occupations
S2020
S2000
S1900
S1950
D1950
D2000
D2020
D1900
Quantity of Labor
13-8
Model of the Competitive Labor Market
• Characteristics of a competitive
labor market include:
–Numerous firms competing to hire
a specific type of labor
–Many qualified workers with
identical skills available to supply
this type of labor service
–Both employer and employee are
“wage takers” in that neither can
control the market wage rate
13-9
Model of the Competitive Labor Market
• The market demand for labor is determined by summing
horizontally the labor demand curves (MRP curves) of
the individual firms
Model of the Competitive Labor Market
• The market supply of labor will be
determined by the amount of labor offered at
different wage rates; more will be supplied at
higher wages because the wage must cover
the opportunity costs of alternative uses of
time spent either in other labor markets or in
leisure activities
• The market equilibrium wage and quantity of
labor employed will be where the labor
demand and supply curves intersect
• This occurs at a $10 wage and 1,000
employed
Model of the Competitive Labor Market
• Individual firms will take this wage rate as
given, and will hire workers up to the point at
which the market wage rate is equal to the
MRP of the last worker (according to the
MRP=MRC rule)
• Note that the demand curve in Figure 13.3 is
based on figures from Table 12.1 in the last
chapter
• For each firm, the MRC is constant and
equal to the wage because the firm is a
“wage taker” and by itself has no influence
on the wage in the competitive model
Model of the Competitive Labor Market
Competitive Labor Market
Labor Market
Individual Firm
a
($10)
WC
($10)
WC
D=MRP
(∑ mrp’s)
0
Wage Rate (Dollars)
Wage Rate (Dollars)
S
QC
(1000)
Quantity of Labor
0
e
b
c
s=MRC
d=mrp
qC
(5)
Quantity of Labor
13-14
Monopsony Model
• Monopsony is a market in which a
single employer of labor has
substantial power over hiring
– There is only a single buyer of a
particular type of labor
– The labor immobile, either
geographically or because of lack of
skills
– The firm is a “wage maker” because
the wage rate it must pay varies
directly with the number of workers it
employs
13-15
Characteristics of the Monopsony Model
• The labor supply curve will be upward
sloping; if the firm is large relative to the
labor market, it will have to pay a higher
wage rate to attract more labor
• As a result, the marginal resource cost
(the cost of hiring labor) will exceed the
wage rate because the higher wage paid
to additional workers will have to be paid
to all similar workers employed
Characteristics of the Monopsony
Model
• Therefore, the MRC is the wage rate of an
added worker plus the increments that will
have to be paid to others already employed
• Equilibrium in the monopsonistic labor
market will also occur at MRC=MRP
• However, now the MRC is above the wage
so the wage will be lower than it would be if
the market were competitive
• As a result, the monopsonistic firm will hire
fewer workers than under competitive
conditions
Characteristics of the Monopsony Model
• For example, one worker can be hired at a wage rate of $6.
• To hire the second, you would pay him/her $7 plus $1 to the first
worker or you would have unhappy workers!
– The MRC for the second worker is $8
• To hire the third worker, you would pay them $8 plus $1 for each of
the first two, making the MRC of the third worker $10
• Key point: the MRC cost for the Monopsonist exceeds the wage
rate and lies above the average labor supply curve S
Monopsony Model
Wage Rate (Dollars)
MRC
S
b
a
Wc
Wm
c
MRP
0
Qm
Qc
Quantity of Labor
• Examples of monopsony power
13-19
Monopsony Model
• Conclusion: in a monopsonistic labor
market there will be fewer workers hired
and at a lower wage than would be the
case if that same labor market were
competitive, other things being equal
– Nurses paid less in towns with fewer
hospitals
Union labor models
• With unions, employers do not deal directly
with the individual workers, but with their
unions who try to raise wage rates in several
ways
• Demand-Enhancement Model
– Unions prefer to raise wages by increasing the
demand for labor
– Unions may try to increase the price of substitute
resources, thus increasing the demand for union
workers (supporting politically a higher minimum
wage)
– Unions can increase the demand for labor by
supporting public actions that would result in the
construction of mass-transit systems where
unions would supply most of the workers
Demand Enhancement Model
• Union model
Wage Rate (Dollars)
–Increase product demand
–Alter price of other inputs,
such as minimum-wage
S
Increase
In Demand
Wu
Wc
D2
D1
Qc
Qu
Quantity of Labor
13-22
Exclusive or Craft Union Model
• The members of Craft Unions possess a particular skill such as
brick masons, carpenters, or plumbers
• The craft unions are able to raise wage rates by restricting the
supply of workers
– Large membership fees; compulsory retirement
– Long apprenticeships; shorter work week
– Forcing employers to hire only union workers
13-23
Inclusive or industrial unions
• Industrial unions include companies such as automobile workers
and steelworkers
• They seek both skilled and unskilled workers so they have the
power to impose a higher wage than the employer would otherwise
pay
• The bargained wage becomes the MRC for the employer between
point “a” and “b”
Inclusive or industrial unions
• In fig. 13.7, the competitive equilibrium wage is
Wc and the level of employment is Qc
• An industrial union might demand a higher wage
rate of Wu
• That wage rate Wu would create a perfectly
elastic labor supply over the range ae
• If firms wanted to hire any workers in this range,
they would have to pay the union-imposed wage
rate
• If they decide against this, they would face a
strike
• If firms decide to pay the higher rate, they will cut
back on employment from Qc to Qu
Inclusive or industrial unions
• Note from point e on the labor supply curve that
Qe workers desire employment at wage Wu
• But as indicated by point b on labor demand curve
D, only Qu workers are employed
• As a consequence, a surplus of labor of Qe-Qu
results
• In a competitive market, the effect of surplus of
unemployed workers would be lower wages.
• However, with a union, individual workers can not
work for less and employers can not pay less than
that
Union Models
• Are unions successful?
• Wages 15% higher on average
• Consequences:
–Higher unemployment
–Restricted ability to demand higher
wages because of the effect of
increasing unemployment within
the unions
13-27
Minimum Wage
• The minimum wage controversy
concerns the effectiveness of
minimum wage legislation as an
antipoverty device
• The Federal minimum wage has
ranged between 30 and 50
percent of the average wage paid
to manufacturing workers in 2007
13-28
Minimum Wage
• The case against minimum wage contains
two major criticisms
– The minimum wage forces employers to pay
a higher than equilibrium wage, so they will
hire fewer workers as the wage pushes them
higher on their MRP curve
– The minimum wage is not an effective tool to
fight poverty. Some minimum wage workers
are teens or from affluent families who do not
need protection from poverty
Minimum Wage
• The case for minimum wage indicates that
minimum-wage laws occur in markets that
are not competitive and always changing
• In a monopolistic market, the minimum
wage increases wages with minimal
effects on employment
• Increasing minimum wage may increase
productivity: managers will use workers
more efficiently when they have higher
wages; minimum wage may reduce labor
turnover and thus training costs
Wage Differentials
• Wage differentials can be explained by
using supply and demand for various
occupations
• Given the same supply conditions,
workers for whom there is a strong
demand will receive higher wages
• Given the same demand conditions,
workers where there is a reduced supply
will receive higher wages
Labor Demand, Labor Supply and Wage Differentials
Wage Differentials
Average Annual Wages, 2007
Occupation
Surgeons
Aircraft Pilots
Petroleum Engineers
Financial Managers
Law Professors
Chemical Engineers
Dental Hygienists
Registered Nurses
Police Officers
Electricians
Travel Agents
Barbers
Retail Salespersons
Recreation Workers
Teacher Aides
Fast Food Cooks
Annual Average Wages
$191,410
148,810
113,890
106,200
95,510
84,240
64,910
62,480
50,670
48,100
32,190
25,860
24,530
23,790
22,820
16,860
Source: Bureau of Labor Statistics, 2006
13-33
Labor Supply and Demand
•
•
•
•
Differences across occupations
Explains wage differentials
Marginal revenue productivity
Noncompeting groups
–Ability
–Education and training
• Compensating differences
13-34
Labor Supply and Demand
• A workers contribution to the employer’s
total revenue (MRP) will depend upon the
worker’s productivity and the demand for
the final product
• On the supply side, workers are not all the
same, i.e., they are in noncompeting
groups which differ by:
– Ability level
– Education and training
Education levels and individual earnings
Labor Supply and Demand
• Wage differentials may also exist because
of nonmonetary aspects of a job
– Physically hard
– Fear of being laid off
– Unsafe job
– Poor advancement opportunities
Inability to go from a lower to higher paying job
(Market Imperfection)
• Workers lack information about alternative
job opportunities
• Workers may be reluctant to move to other
geographic locations
• Artificial restraints on mobility (some
municipalities require that you live within
them if you are employed by them)
• Discrimination in certain labor markets may
crowd women and minorities into certain
labor markets and out of others
– This is referred to as occupational segregation
Pay for Performance
• The principal-agent problem
occurs when the interests of the
worker and the firm are not
identical
–Workers will act to improve their
own well-being, often at the
expense of the firm
–Loafing on the job, using company
materials, just not working very
hard
13-39
Principal-agent problem
• Incentive methods sometimes help to avoid
the principal-agent problem
• With piece-rate payments, workers earn
according to the quantity of output produced
• Commissions and royalties are payment
schemes linked to the value of sales
• Bonuses, stock options, and profit sharing
are other ways to motivate workers
• Efficiency wages also may provide an
incentive through paying above average
wages
Negative sides to the incentive approach
• A rapid production pace can compromise
quality and endanger workers
• Commissions may cause salespeople to
exaggerate claims
• Bonuses based on personal performance
may be resented by fellow workers
• Less energetic works can take a free ride
in profit sharing firms
• Firms paying “efficiency wages” may have
fewer opportunities to hire new workers
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
13-42
Key Terms
• wage rate
• minimum wage
• nominal wage
• wage differentials
• real wage
• marginal revenue
productivity
• purely competitive
labor market
• noncompeting groups
• monopsony
• human capital
• exclusive unionism
• compensating
differences
• occupational
licensing
• incentive pay plan
• inclusive unionism
• bilateral monopoly
13-43
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Rent, Interest,
and Profit
13-44