Wage Differentials

The wage paid to workers varies greatly. These wage differentials are mostly the result of differences in worker ability and the workers' effort in performing the job, but may also result if the job is unionized, since the goal of labor unions is to increase compensation over and above what would otherwise be provided based on free market conditions. There are also wage differentials across occupations, because of differences in the demand and supply of laborers for particular jobs or occupations. These differences arise primarily because of differences in the amount of education or training required and in the desirability of the job itself.

Minimum Wage

Most governments impose a minimum wage, the minimum an employer may pay an employee. The purpose of the minimum wage is to enable unskilled workers to earn a living.

Many economists are critical of the minimum wage because, as they argue, it reduces total employment — some workers benefit from the higher wage while others are unemployed because of reduced demand for the higher-priced labor. Moreover, many people earning the minimum wage are often people who do not need to maintain their own living, such as teenagers who still live at home. Indeed, many of these teenagers live in middle class households.

Graph showing how the minimum wage may reduce the demand for labor but only if the market wage is below the minimum wage.
The shaded area in the above diagram represents the total unemployment if the market wage was 0, which is unrealistic. If the market wage is below the minimum wage, then the amount of unemployment would be the difference between employment at the minimum wage and employment at the market wage. If the minimum wage is below the market wage, then the minimum wage has no effect on unemployment.

However, others argue that the minimum wage is so minimal that it has little effect on actual employment and that the minimum wage helps to reduce turnover, which helps to reduce the employer's cost of training new employees. If employers paid as little as possible, then workers would continually search for higher paying jobs.

The consensus seems to be that the benefits of the minimum wage outweigh its drawbacks, especially since increases in the minimum wage have not had a measurable impact on the level of employment.

The Effect of Minimum Wage Laws: The Macroeconomic Perspective

When considering only the law of supply and demand for an employer — the microeconomic perspective — minimum wage laws increase unemployment by increasing the price of labor, hence, lowering the demand for labor. However, from a macroeconomic perspective, minimum wage laws may actually increase employment! Why? Because the marginal propensity to consume increases with lower incomes. By increasing wages for low-income workers, they will spend most of the money they receive, thus stimulating the economy. Additionally, as increases in technology make each worker more productive, the price of labor becomes a smaller part of the cost of products and services, so raising the minimum wage will only increase market prices minimally, if at all.

Occupational Wage Differentials

Obviously, certain occupations pay more than others. Surgeons make more than teachers, who make more than retail salespeople. Most of these wage differentials are the result of educational and training requirements, often called human capital. Surgeons require more than a decade of education and training after high school before they can earn a living as surgeons, while retail salespeople can get a job right of high school, or even while they are still in school.

Education and training limit the supply of labor in that they take a minimum time to complete and require a certain level of skill. Many people who attend college or training school do not have the time to work a full-time job. Therefore, they also incur an opportunity cost equal to the amount of money they could have earned had it not been for the educational or training requirement.

Another primary factor determining wages is the demand for the worker, which is a derived demand for the product or service the worker provides. If the worker provides a highly desirable product or service, then a higher wage will prevail for a given supply of workers who could do that job.

Sometimes, ability makes a very large difference in wage potential that far outweighs the differences in ability. The winning horse earns a lot more than the one that comes in 2nd even though it is only a little faster. There are only so many jobs for professional athletes, so only the very best will be chosen for those high-paying jobs. Likewise, only the best musicians or those producing the most desirable music will become wealthy. People only have so much time and money for entertainment, so they tend to select entertainment performed by the best people, especially entertainment packaged for mass consumption.

Compensating Differentials

Some jobs pay more because they are less desirable. They may be hazardous, dirty, and employment may be sporadic or seasonal. For instance, construction pays more than retail sales because of these compensating differentials, which are nonmonetary differences between jobs where higher or lower wages are paid because of differences in the desirability of the job itself. Most retail jobs take place in air-conditioned or heated stores where the worker can wear nice clothing, stay clean, engage in friendly conversations with customers, and expend little physical effort. By contrast, construction workers may perform hazardous work, will become dirty during the job requiring them to spend additional time cleaning up afterwards, and will often have to work long hours to get the job finished, and they may not get work during the winter months. Hence, to attract enough workers to construction, the industry must pay more.

Status or power, or the lack thereof, may also be a compensating differential. After all, you never hear a kid saying I want to grow up to be a garbage collector. On the other hand, much more money is spent to elect someone to the presidency of the United States than they will ever earn at the job, and many lawyers earn more than Supreme Court justices, yet few of those lawyers would turn down an appointment to the Supreme Court.

Wage Differentials Due to Locality

For any given type of job, wages are usually higher in one locality than in others. Much of this difference is because of differences in the cost-of-living. However, most people are reluctant to move because they do not want to leave their friends, sell their house, be subjected to the cost and uncertainty of a new job in a new community, and the children may not want to change schools. People may also be unwilling to give up pension plans, health insurance, or seniority at their current job. Hence, wage differentials in different localities may persist, even if people know that higher wages can be earned elsewhere.

The requirement for occupational licensing may also be an impediment to moving to a different area for higher wages. Many occupations require state licensing, such as law and medicine, so if a licensed worker wanted to move to a new state, she would have to obtain a new license and may have to satisfy additional requirements. Many localities also have their own licensing requirements for certain occupations, such as for beauticians or barbers.

Wage Differentials Due To Market Imperfections

In economics, there is a presumption that people will migrate to higher paying jobs from lower paying jobs of the same type and with the same requirements. However, this can only happen if people know about the jobs. People tend to look for jobs in their own locality by searching the local newspaper or local Internet listings. Moreover, many people get jobs from their network of friends and acquaintances, who tend to live in the same area. Hence, the lack of information can lead to persistent differences in wage differentials for the same type of job.

Performance Pay

Many occupations pay a wage rate commensurate with performance, such as sales or managerial occupations. The purpose of performance pay is to attract the most highly qualified and productive workers, or as economists like to say, workers with highest marginal revenue productivity.

Performance pay is also used to motivate workers to work. Many employees paid a flat wage rate often linger or dawdle, which lowers their productivity and the employer's marginal revenue product. Dawdling employees can also lower morale, since harder working employees resent being paid the same as the dawdling employees. Performance pay helps to solve this principal-agent problem by aligning the interests of the employees with the owners of the firm — both want to make more money.

There are various types of performance pay. Piece rates are paid according to the amount of work accomplished. Many factories use piece rates to prevent dawdling.

Commissions are often paid as a percentage of sales, in such industries as real estate, insurance, securities, and retail sales. Royalties are paid to artists who actually create a product and, like commissions, is usually a percentage of the sales price of the product. For instance, authors may receive 10% of the book price for each book they sell.

Bonuses and stock options are often paid to executives of the company so that they work harder to ensure that the company will succeed. Bonuses are lump sum payments paid at the end of the year after the employee's performance can be assessed. Stock options align the interests of executives of the company with those of the shareholders — if their shareholders profit, then they will too. Profit-sharing plans pay a percentage of the firm's profits to employees so that they work harder.

Firms may also pay efficiency wages, which are higher than market wages, to attract more productive workers. Efficiency wages may lower the firm's cost of labor by hiring only productive individuals, with lower turnover, which can result in a more experienced workforce. Consequently, recruiting and training costs are also lower. Good employees also require less supervision and monitoring. Besides attracting the best workers, efficiency wages can make the threat of being fired more effective. If a worker is earning a regular wage at one company, then the threat of being fired is not much of a threat if he can easily find a job elsewhere paying the same wage. On the other hand, if he loses a job earning efficiency wages, then he will be less likely to find other employment paying a comparable wage. Henry Ford was an early proponent of efficiency wages, when in 1914, he increased the wages of his workers at the Ford Motor Company to $5 a day, double the going rate for mechanics at that time.

Drawbacks to Pay Incentives

There are some drawbacks to incentive pay: