Wage Determination

Think of Anna, who has just finished med school. She is being interviewed by a hospital and trying to negotiate the wage with them. However, that hospital is the only hospital where Anna lives. To what extent will that affect Anna's wage? How is Anna's salary determined? What are some of the factors that influence wage determination? 

Wage Determination Wage Determination

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    We invite you to read this article and get to the bottom of it to find out the answers to these questions and much more!

    Wage Determination in Labor Market

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

    The labor market refers to the marketplace for workers where those seeking a job and those seeking to find a worker meet.

    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.

    The market theory of wage determination aims to explain the discrepancies in income that a lot of different individuals get through worker's abilities.

    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.

    For instance, if there is a low demand for doorkeepers but a relatively ample supply of doorkeepers, the end effect would be lower salaries for doorkeepers. Think about it: as there is low demand and high supply, employers can choose the doorkeeper who asks for the lowest wage.

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

    An example of this could be professional software developers. In this market, higher salaries result from a limited supply of skills compared to the comparatively high demand for that ability.

    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.

    The theory of negotiated wages is one labor market theory that argues that labor unions' bargaining power determines wages.

    For instance, a powerful labor union may be able to coerce some companies into paying higher salaries. This is because the companies in question would be unable to withstand the financial impact of a strike if it was called.

    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.

    We have an entire explanation that covers Labor Unions in the United States - feel free to check it out!

    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.

    Think about a professor of Economics who made the book you studied in high school and designed the curriculum for most high schools in the U.S. that provide Economics courses. This professor has been through extensive certifications and programs and has dedicated their life to economics research. This professor indeed gets a higher pay than the teacher you have in your high school.

    Wage Determination Diagram

    The wage determination diagram consists of two important elements:

    the demand for labor and the supply for labor.

    The demand for labor refers to the relation between the wage rate employers are willing to pay and different quantities of labor supplied.

    The supply for labor is the relation between the number of hours individuals are willing to supply and different wage rates.

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

    Wage Determination Wage Determination Diagram StudySmarterFig. 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 market refers to the type of market where there is a large number of buyers and sellers, and none of those is capable of influencing the price.

    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.

    A perfectly elastic labor supply means that a change in the wage rate would lead to no workers offering their labor services.

    Wage determination Wage determination in competitive markets StudySmarterFig. 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.

    We covered perfectly competitive labor markets in greater detail.

    Check it out here: Perfectly competitive labour markets

    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.

    An imperfect market is any market in which buyers and sellers influence the price, and it does not meet the requirements of a competitive market.

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

    Imagine that there is only one employer in a particular labor market. Because this business does not have direct competition in the recruiting process, if they offer lower wages than what would exist in a market where there is rivalry for labor, workers will have few alternatives to choose from. They have no choice but to agree to the terms of employment if they wish to find work.

    Consider the challenges surgical nurses face in a community with a single hospital. It's not that uncommon for employers to have at least some market leverage over prospective workers to work for them.

    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.

    Wage Determination - Key takeaways

    • The labor market refers to the marketplace for workers where those seeking a job and those seeking to find a worker meet.
    • There are a couple of theories of wage determination, including the market theory of wage determination, the theory of negotiated wages, and the signaling theory.
    • The demand for labor refers to the relation between the wage rate employers are willing to pay and different quantities of labor supplied.
    • The supply for labor is the relation between the number of hours individuals are willing to supply and different wage rates.
    Frequently Asked Questions about Wage Determination

    What are the 3 theories of wage determination?

    • The market theory of wage determination
    • The theory of negotiated wages 
    • The signaling theory

    What are the determinants of wages?

    One of the main determinants of wages is the skill set of workers and the industry they are in

    How wages are determined in the labor markets?

    By the interaction of demand and supply.

    How is wage determined in a perfect market?

    The marginal revenue of labor has to be equal to the marginal cost of it.

    How is the wage rate determined in a monopoly labor market?

    The party that has power over the market can decide to increase or decrease the wage.

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