Wage Determination

Wage Determination in Labor Market

Before we discuss wage determination in the labor market, let's consider the labor market in general.

The labor cost - the wage individuals get paid, varies according to the job's nature.

The difference in the level of skills and knowledge one has play an important role in explaining how the wage is determined. There are four main categories of labor: unskilled, semiskilled, skilled, and professional.

• Unskilled labor consists of job occupations that do not require skills.
• Semiskilled labor refers to job occupations that need a minimum amount of skills to operate the machines.
• Skilled labor refers to occupations requiring complex skills to use the equipment they work with.
• Professional labor refers to the workers with the highest skill and level of education.

The closer you are to being a professional, the higher you get paid.

Although every labor market is unique, most of them function in ways that are comparable to one another. For instance, when wages increase in one labor market, they also grow in other labor markets.

Much like every other market, the labor market is driven by supply and demand. Why is it that businesses need labor? Why is an employer prepared to compensate you financially for your work?

It's not because your employer is a kind person or because they care about the community. Instead, it's because your job is valuable to the company and helps bring in money for the company thanks to your efforts.

How much are employers willing to pay their employees? That will be determined by the knowledge and expertise that you offer to the company. A company will never pay someone, whoever that may be, more than the additional value they add to the company.

There are two different types of labor markets:

• perfectly competitive
• imperfectly competitive

In a perfectly competitive labor market, the wage is determined where demand and supply intersect. The employer and employee are wage-takers, meaning they can't influence the wage.

However, in imperfectly competitive labor markets, the wage can be influenced by either the employer or the employee.

Theories of Wage Determination

There are a couple of theories of wage determination:

1. market theory of wage determination
2. the theory of negotiated wages
3. the signaling theory

Let's go over each of them in turn!

Market Theory of Wage Determination

Market theory of wage determination is one of the theories of labor markets that aim to explain how wages are determined.

According to this theory, the pay or salary of a worker is determined by the supply and demand for the worker's abilities and services in the market.

Wages would be much higher if the current circumstances were to be reversed, with demand being high and supply being low.

The market theory could seem liable to certain kinds of deviations. There are instances of employees who are not productive but nevertheless obtain high salaries due to family connections or political influence. Workers with high levels of expertise may be subjected to pay discrimination based on their race or gender, resulting in lower salaries.

The Theory of Negotiated Wages

According to the idea of negotiated wages, one factor contributing to deciding wages is the negotiating power of labor unions.

Seniority, or the amount of time a person has spent working for the same company, is a criterion that is considered by unions. Even though they may not have stronger abilities, some employees obtain more compensation than others who do equivalent duties because of their seniority in the company.

The signaling theory

According to the signaling theory, companies are more likely to provide higher salaries to job candidates with certificates, degrees, and other credentials that "signal" more excellent knowledge or skill. Due to these qualifications, specific individuals have a higher salary than others.

Wage Determination Diagram

The wage determination diagram consists of two important elements:

the demand for labor and the supply for labor.

The interaction of labor supply and labor demand impacts the wage, and ultimately, both parties, those demanding and those supplying, settle on an agreement.

Fig. 1 - Wage Determination Diagram

Figure 1 shows the wage determination diagram. On the horizontal axis, you have the labor quantity. On the vertical axis, you have the wage rate. At the point where the labor demand and labor supply are equal, the equilibrium wage rate and equilibrium quantity are determined. At the equilibrium, workers agree to exchange their services for the wage rate W, and employers agree to pay workers wage rate W in exchange for their services.

But why does the equilibrium in the labor market occur? Well, think about it, if the wage rate was higher than W, there would be much more people offering their labor since they would have the incentive of higher wages to work.

This would significantly increase the number of willing workers, leaving employers with the ability to pick who to hire. This will give leverage to employers, and they will seek people who accept being paid less. As there are many people, some will just settle for a lower wage, and some will simply decline. This will bring the wage rate down to the equilibrium point.

On the other hand, if the wage rate was below the equilibrium point W, employers would be willing to hire more people. However, fewer people are willing to work at lower wages. At some point, employers will have to increase the wage rate they pay to attract those individuals to return to the labor market. This then bids the wage rate up and back to the equilibrium where it was.

Wage Determination in Competitive Markets

Before discussing how wage determination takes place in competitive markets, let's consider what a competitive market looks like.

A competitive labor market consists of many firms. Workers and employers have perfect information about wage rates and job conditions. Many firms offer identical jobs, and all the workers have the same skillset.

One important thing to understand here is that firms are wage takers. That means that the wage is determined in the market, and firms must comply and pay that wage rate. As such, the supply of labor is perfectly elastic.

Fig. 2 - Wage determination in competitive markets

Figure 2 shows the wage determination in a perfectly competitive labor market. A firm will hire labor until the additional revenue from hiring an additional worker equals the extra cost a new worker brings.

The wage is determined at We, and Q1 represents the number of workers a firm is willing to hire.

Note that neither the workers nor the employers have influence over the wage.

Wage Determination in Imperfect Market

When considering wage determination in an imperfect market, think of a job applicant negotiating for a position that he needs more than the employer needs to hire him.

A labor market is considered competitive when there are many possible employers for a particular category of workers, such as secretaries or accountants.

Wage determination in an imperfect market takes place so that the party that has influence over the market wage can either increase or decrease it below equilibrium.