What determines pay?

In a previous post I discussed what determines price with a look at the feedback of supply and demand over time.  I now want to apply a similar logic to labor and compensation.  When we talked about price there’s a bottom value determined by the cost of the materials.  No matter how low demand stays price can’t stay below this level because no-one would bother to make the product.  Similarly there’s a top value on pay determined by the amount of value an employee creates for the company.  If an employee assembles 1,000 widgets a day and each widget sells at a $0.30 profit then the maximum that he can be paid is $300/day without running a loss.  Of course it’s not that simple.  The employer also has to pay for electricity to build the widgets, and  the building where the widgets are built, and %6.5 of the pay has to cover his share of the employees Social Sec and medicare, and he contributes to the employees health insurance, and he has to pay for all the machines used to make the widgets, and a thousand other expenses I can’t think of because I’ve never run a business.

So if the upper limit on pay is based on the value created by the employee, what determines the lower limit?  Now we’re back to the question of supply and demand.  How many of this job are out there?  How many people are able to do it?  There’s also an issue of anchoring or “stickiness.”  Did I bring this up in “what determines price?”  Price stickiness refers to the human tendency to think that what we have been paying for something is the “fair” price and when the price is raised we feel cheated or betrayed.  This can overcome habit and brand loyalty and make us search for substitute goods.  This is more in the realm of psychology than traditional economics, but real-life is messy and involves both.  Stickiness applies to wages as well as to prices.  If your boss came up to you and said, “Sales are down, we’re going to have to ask you to take a 10% paycut”  you would be shocked.  Irate even.  Morale would drop.  Productivity would drop.  You would be far more likely to consider other job offers, after all if this is how he treats you why should he deserve your loyalty?  If you let them do it once what’s to stop them from doing it again?  Employers would love to do this.  The normal salary contract puts all the market risk on the employer and the employee gets a relatively free ride.  Of course if we had higher risk tolerances we’d all be self-employed.  (I know if I had a higher risk tolerance I’d be running a summer camp called “Ninja School.”)  Since employees won’t tolerate pay cuts the alternative is to get rid of the unproductive employees.  No fault of theirs, but if nobody’s buying widgets we can’t afford to pay people to stand around and not make them.  Then when the business cycle rolls back the other way and demand for widgets goes up we won’t have enough workers, and we’ll have to advertize, interview, hire, and train them… all the while profits are being lost.

Another thing that distorts supply vs demand in the wage market is the labor union or the trade guild.  When large groups of workers with similar skills act as a block and refuse to work for less than a certain wage (or benefits package, or vacation time…) it raises the wages even of those who aren’t part of the organization.  This is analogous to the oil cartels deliberately setting the amount oil produced to hit a certain target price.  In the price scenario the long term trend was for new businesses to come into the market and increase the supply until profit margins returned to average levels.  In the wage scenario it is unaffiliated workers and “scabs” that come into the market and increase the labor supply to drive wages back down.



  • Top wage is determined by productivity / value added
  • Bottom wage is determined by subsitance / safety-net effects
  • Actual wage is primarily determined by number of job openings and number of workers with requisite skills
    •                 Wages are driven up by organized labor
    •                 Wages are held up by stickiness
    •                 Wages are driven down by market corrections and corporate profit targets

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