Determinants of Wages
Microeconomic studies on wages are not new in modern economies. They have become crucial in understanding how much firms should pay their employees and what employees should expect. Such studies concerning the degree of wage rigidity mostly focus on employees' wages in current relationships. The labor allocation theory states that there is demand and supply in demand, just like there is any in any other market. The labor market is a huge one. It has become one of the most crucial subject economies students will have to take before they complete their studies. And many studies seek to uncover what the subject has to offer. Many other studies have focused on the rigidity of hired workers, where rigidity is the absence of deviations of the wages paid to new hires to other employees with the same competence levels. These studies have come up even more rapidly today amidst the importance of job creation and the character of employment and wages in the economic cycle.
One good approach to this issue is the macro-economic model that allows for varying degrees of rigidity I the compensation of new hires against incumbents with the same level of skills. According to de Walque et al. 2009, a higher stickiness of wages for new hires compels the company to respond to shock by adjusting employment. This causes a subdue in response to nominal wages and inflation to shocks. Many other empirical studies on the rigidity of wages, mostly on the earnings for individuals shifting between jobs with rigidity being considered based on how much macroeconomic conditions impact on wages of job changers have also contributed much to this subject.
With all these studies, it is clear that wage and salary structures play a crucial role in economic development. As stated above, there is demand and supply in the labor market, where households are the suppliers, and firms are the consumers. So, why should you be paid for your labor? Why should firms spend huge amounts of money paying for your services? It is because labor is one of the key pillars of the production process. If a firm does not have the right employees, they will not meet their goals because they don't have the right tools for the job. Hence, the labor allocation theory mentions the need for investing in human resources.
Many companies take their employees for further studies and training to equip them with the right skills to handle consumers' growing demand. New technologies and inventions are coming up to make the world a better place, and many markets are taking advantage of these developments. Basically, wages are determined by the markets in which the particular labor markets operate. It is also worth noting the labor depreciates. When there are high unemployment rates, and someone with skills stays long without using those skills, they may not be useful when the opportunity finally comes up.
In underdeveloped economies, wage and salary structures bear both economic and political interest. As opposed to economic theory, there is a wide gap between earnings in unskilled wage-employment and in the peasant agriculture fields. The differences between unskilled, uneducated works, and skilled, educated labor are often underdeveloped than in developed countries. And since markets determine wages and salaries, the minimum and maximum wages depend on how much the economy has developed.
In simple terms, the main determinant for wages is the economic development of a country. Today, many have invested in creating a good background for their markets by investing more in proper education and training. Developed nations offer support for students through higher learning institutions. Less developed countries still struggle with educating their people, which makes it even harder to have strong labor markets.
As we have seen, different categories of labor market – skilled and unskilled labor, each of them comes in different levels of compensation plans for their workers. Mostly, one is paid based on the level of education and skills they offer to the firms. Employees who come with higher levels of education are paid more salaries than those with less education. Much economic literature centers on the market determination of unskilled wages, especially in dual economies which have migrant or surplus labor.
Conditions of equilibrium in the labor market
There needs to be a marginal revenue product of labor equal to the wage rate and that MPL/PL is equal to MPL / PK. This is another condition used by labor markets to determine wages. Firms often hire more labor when the marginal revenue product of labor is higher than the wage rate. They will stop hiring immediately. These two values are equal.
The labor market is a bit different from the market for goods and services. This is mainly because labor is a derived demand. This means labor is not desired for its own sake but because it is crucial in producing output. Firms use profit maximization approaches, seeking to produce the optimum level of output and the lowest possible cost, in determining their demand for labor. For this reason, a firm will pay for its workers based on the input they give in to the firm. For profit-maximization, the number rule is that the wages should not be more than the employee's input. Take, for instance, an employee that makes $2 dollar widgets for a firm per hour if the company sells each at $10, this worker maker $20 for the company. The maximum wage they can receive is $20 because that is what they make for the company.
A firm will determine its demand for labor based on such a lens of maximum profit gain. They seek to produce an optimum level of output at the lowest possible cost. Firms seek to make the most profit from what they do, which is why they will use the least input for the most benefits. Economists follow various assumptions to find the equilibrium quantity and the price of labor. In other words, they use models to break down and explain such complex issues as the labor markets.
The first assumption for labor market equilibrium is that the marginal product of labor (MPL) is decreasing. It is also assumed that firms are price takers in the goods markets as they are in the labor market. This means, just like they cannot affect the price of output, they cannot affect the wage rate. In many economies, there are clear laws and guidelines on the minimum wages to help people cope with living standards. The third assumption is the supply for labor is elastic and increases with the wage rate, and fourth, those firms are profit-maximizers.
The marginal revenue product of labor (MRPL) is equal to the MPL times price of output. MRPL stands for the additional revenue that a firm can expect when they employ additional labor units. This is the benefit of the firm from the labor provide. Following these assumptions, the MRPL decreases as the number of labor increases, and hence, firms can make more profit by hiring more labor is the MRPL is above the marginal cost of the extra unit of labor. This is known as the wage rate. If the MRPL is greater than the rate of wages, a firm can hire more labor. And immediately, these two values hit an equilibrium, and the firm may cease to hire. The labor market equilibrium is the point at which the MPRL is the same as the existing wage rate.
As stated above, firms are profit-takers. Their long-run goal is to maximize profit by choosing the optimal combination of labor and capital to produce a given output amount. There is a possibility of an automobile company to make 1,000 cars with the help of one expensive, tech-advanced machine that hires human involvement. The same company could also make the same product using only labor, not the technology and machines. In industries, it is not possible to rely solely on labor, as it is more expensive, and hence, they use a combination of the two.
An interaction between supply and demand characterizes the labor market. There must be demand for labor for people to get jobs, and there must be supply for firms to get good workers. It is this relationship that determines the wage rate.
In other words, if labor is output to production, the firm involved will hire work. Firms demand labor, and workers' supply is based on a price called wage rate. Hence, the wage rate is just the labor price – the dollar amount a worker receives for their work. In economics, however, it is the total compensation, which includes all the benefits. The lowest benefit of hiring one more unit of labor is the marginal product of labor.
There are so many things that affect labor pricing if we follow this model, which also determine wages in a market. The changes in supply and demand are common issues in these markets. For competitive markets, the demand curve for labor is one the same level of characteristics as the marginal revenue curve. Hence, the demand for labor is a function in the alteration of minimal PoL. Several reasons may cause these features. For instance, if a company introduces a new product, there is a representation of new demand in the labor market.
Technology also affects the output of unit labor. When there are new technologies on the market, companies rush to take them as competition grows tighter. Another factor that affects the shift in the labor demand curve is the changes in the output price, which affect the value of the unit labor. There is also the price of labor relative to other factors of production. Labor supply also depends on the population.
What factors determine wages then? Now that we have seen how firms behave in a competitive labor market, it will be a good idea to summarize the factors that determine wages. We have seen the main factor as the markets themselves, where demand and supply affect these firms' decision-making processes.
Here is a summer of these factors:
- When the industry is able to pay. The ability of the industry to pay will has a huge influence on the wage rates. If there are risks of losses, it becomes impossible to pay high wages A profitable enterprise seeks to attract better employees, and hence, they will pay higher wages.
- Demand supply. Shifts in competitive markets cause economic cycles. When production is high, it leads to demand for labor, and when it is low, it causes negative effects with less demand for labor amidst high demand. Demand is low when supply is high, and vice versa.
- Current market rates. As stated above, firms are wage takers are they are price takers for goods and services. Therefore, not a firm can ignore then current wage rates in their markets. These wages form the basis of fixing wage rate issues and other related concerns. If one unit or concern pays low rates, workers will be quick to leave their work to search for better jobs. Such a firm cannot retain workers for long.
- Cost of living. The cost of living in developing economies is quite high. And this is there are set minimum wage by the government to help people deal with life. In other words, the wage rate comes under the direct influence of the cost of living in a place. Workers accept wages that enable them to afford a minimum standard of living.
- The bargaining of Trade Unions. Trade unions have a major role in determining wage rates. Strong trade unions achieve higher rates.
- Productivity. Workers' productivity determines how much they are paid. Also, firms may bring in other factors like machines, material, and management to help boost productivity. Works also receive bonuses to encourage them to work harder.
Wages are part markets, and every firm must learn their impact and approaches. It is one of the determinants of a good relationship between suppliers and demanders for laborers, apart from affecting the general economy.
Author: James Hamilton