Wages: Factors That Affect Wage Levels and Wage Determination under Pure Competition

Most people work to earn a living, which they do by supplying their labor in return for money. Laborers consist of unskilled workers, blue and white collar workers, professional people, and small business owners.

Wages are the price that workers receive for their labor in the form of salaries, bonuses, royalties, commissions, and fringe benefits, such as paid vacations, health insurance, and pensions. The wage rate is the price per unit of labor. Most commonly, workers are paid by the hour. For instance, in 2011, the legal minimum wage rate for most employees in the United States was $7.25 per hour. Earnings equals the wage rate multiplied by the number of hours worked, so an employee earning minimum wage and working the typical 40-hour week earns $7.25 × 40 = $290 per week = $15,080 per year.

Nominal wage is the amount earned in terms of dollars or other currency, while the real wage is the amount earned in terms of what it can actually buy. If the nominal wage does not increase as much as the inflation rate, then real wages decline.

Wage Levels

Wages differ among nations, regions, occupations, and individuals. Generally, wages will be higher where the demand for labor exceeds the supply. Nominal wages vary more than real wages, since the purchasing power of different currencies varies considerably. For instance, in countries with low-priced labor, such as China and India, household goods and services have lower prices than in more advanced economies.

The main factor that determines the upper limits of wages is the productivity of the business in combining inputs to produce socially desirable outputs. Obviously, more productive workers can be paid more. Productivity largely depends on the availability of real capital, in the form of machinery and automation, and on the availability of natural resources, which are required as inputs in the production of products and services.

The amount of education or training also largely determines how much a worker can earn, not only by making the worker more productive, but by also making the worker more desirable to employers, who compete for workers through the level of wages that they offer. If the time required for training or education is long, then it must lead to higher paying jobs; otherwise, people would pursue easier work or work that can be attained in less time, if there was no difference in pay.

The quality of the entrepreneurs who start a business will also determine the efficiency of the business since they lay down the initial organization of how the business will be conducted to produce its output from its various inputs. Afterwards, the quality of the management will affect the efficiency of the business, and therefore, the workers, by how effectively they control costs and produce the desired output.

Another factor affecting productivity is the political and social environment of the country or region in which the business is located. Many governments, especially in corrupt countries, interfere with the development of businesses or try to extract payments, in the form of bribes, from businesses for the enrichment of particular people in the government rather than using it as tax revenue for the benefit of society. In the same way that mismanagement can reduce the efficiency of workers in a business, the mismanagement of a country can likewise reduce the efficacy of its people. For instance, after Saudi Arabia, Iran and Venezuela have the largest oil reserves in the world, and yet, the people live in poverty. Russia, the largest country in the world by far and rich in natural resources, has a lower GDP than little South Korea, even though Russia has almost 3 times the population.

Many businesses that are unionized are often less productive, since they are constrained by the demands of the union or by union contracts. For instance, unions often resist automation, and other cost-saving changes to project jobs. The size of the market also matters. Larger markets can help promote efficiency in that economies of scale can be reached.

Wage Determination under Pure Competition

A purely competitive labor market exists when:

The market demand for labor is for a specific type of labor and not necessarily for a specific industry. If one industry paid more than another for a specific type of labor, then more laborers would work for that industry until the wages equalized.

Graph showing wage determination in the labor market under pure competition and the results when a firm hires workers until their marginal resource cost equals their marginal revenue product.

Under pure competition, the wage rate is set by the intersection of the labor supply curve and the demand curve of employers, as seen in Graph #1. As is true of supply curves in general, the higher the wage rate, the higher the supply of labor and the lower the demand. In economics, labor is considered a resource. Therefore, the price of labor is represented as a marginal resource cost (MRC) and the employer's demand for labor is represented by the marginal revenue product (MRP). Employers will continue to hire workers as long as the marginal revenue product of the last worker exceeds his marginal revenue cost (MRP ≥ MRC). In other words, as long as the revenue earned by the workers exceeds their cost, the employer will increase profits by hiring more workers.

The labor market equilibrium occurs at the intersection of labor supply curve and the labor demand curve. In a perfectly competitive labor market, the supply of labor is perfectly elastic, so a firm can hire all the workers that it wants for the market wage rate. The firm will hire enough labor until the MRP of the last laborer hired = MRC. MRC is constant, equaling the resource price, or in this case, the wage rate (Graph #2). The area represented under the MRC line = the cost of labor. Above that line and below the MRP line is the cost for land, capital, and entrepreneurship, which includes a normal profit.

Wage Rates, Labor Supply, and Behavioral Economics

Under conventional economics, the supply of labor is proportional to the wage rate. This simplifies the analysis between wage rates in the supply of labor, but behavioral economics stipulates that psychological factors also affect the supply of labor, where increasing the wage rate beyond a certain point may actually decrease the supply of labor. The supply of labor not only depends on the wage rate, but also by the desire for leisure time, whether the workers are earning their target income, and whether they are satisfied with their status in society. Psychological factors also affect worker productivity.

The desire for income and leisure necessitates a trade-off between them. How wage rate increases affect the supply of labor depends on the competition between the substitution effect and the income effect. With higher wages, leisure time or non-working time becomes more expensive, due to the higher opportunity cost. Therefore, the substitution effect tends to increase the supply of labor, especially at lower incomes.

The income effect, on the other hand, increases the demand for leisure or non-working time, thus decreasing the supply of labor. Hence, whether higher wages lead to an increase in labor supply depends on the competition between the substitution effect and the income effect. However, with higher incomes, the marginal utility of money continually declines, which will lead many individuals to eventually demand more leisure and less work time. The trade-off between income and substitution effects will largely be determined by how well people like their jobs and how much they will enjoy their leisure time. For instance, if people love their jobs, then they may continue to work as many hours even at higher wages.

The desire for more leisure and less work time at higher incomes can also be explained by considering work to be an inferior good, so, at some point, people want more leisure and less work.

Target income is also an influential factor that determines how the level of income, or changes in income, will affect the work-leisure trade-off. People who reach their target income are more likely to seek more leisure time by working less. One advantage of keeping social assistance or unemployment insurance income low is that it will be below the target income for most people, which will increase their desire to search for more work.

Since people are also concerned about their relative position in society, i.e., their status in society, how they compare themselves to others, their perceived status will also largely determine how higher income will affect their desire for leisure. Keeping up with the Joneses generally requires more work and less leisure.

Not all non-working time is spent in leisure, since people must also attend to the details of life, such as taking care of children or cleaning the household. These activities may also be less desirable than work, so, with higher incomes, people may hire other people to take care of the details of life, thereby increasing their leisure time without working fewer hours. So, if people do decrease the time that they work, they will generally increase their time for leisure.

Psychological Factors Also Affect Worker Productivity

The profit of any firm also depends heavily on worker productivity. Psychological factors also affect the productivity of the workers. For instance, a superior work culture may cause people to work harder at any given wage level.

Efficiency wage theory stipulates that workers will work harder and be more productive if they are paid better; if they are paid less, then they will be less productive and seek other ways to work as little as possible. This complicates the assumption of conventional economics that profits or wages are inversely related: when wages go up, then profits decline, and vice versa. Efficiency wage theory proposes that there is a unique wage just high enough to motivate the worker, so that lower wages will lower productivity even though it also lowers costs, and higher wages will not increase efficiency enough to offset the cost of higher wages.