How is wage determined in any market

It is very rare for an entry-level worker to make the same wage as an experienced member of the same profession regardless of their relative levels of productivity because the older worker has had time to receive pay raises and promotions for which the younger employee is simply not eligible.

Discrimination is sometimes responsible for members of minority racial or gender groups receiving wages that are less than wages for the majority group even when productivity levels are the same. Finally, outside forces, such as unions or government regulations, can distort pay rates.

Wages and Productivity in the U. If the economic theory were correct in the real world, wages and productivity would increase together. Some of the disconnect between performance and pay can be addressed with alternate pay schemes. While a salary or hourly pay does not directly take into account the quality of work, performance-related pay compensates workers with higher levels of productivity directly.

One example is commission-based pay. In this type of pay scheme, workers receive some percentage of the profit that they generate for their company. This may be paid on top of a baseline salary or may be the only form of compensation.

This type of system is very common among car salespeople and insurance brokers. Another alternative is piece-work, in which employees are paid a fixed rate for every unit produced or action performed, regardless of the time it takes.

This is common in settings where it is easy to measure the output of piece work, such as when a garment worker is paid per each piece of cloth sewn or a telemarketer is paid for every call placed. In a perfectly competitive market, the wage rate is equal to the marginal revenue product of labor. Just as in any market, the price of labor, the wage rate, is determined by the intersection of supply and demand. When the supply of labor increases the equilibrium price falls, and when the demand for labor increases the equilibrium price rises.

In the long run the supply of labor is a simple function of the size of the population, so in order to understand changes in wage rates we focus on the demand for labor. To determine demand in the labor market we must find the marginal revenue product of labor MRPL , which is based on the marginal productivity of labor MPL and the price of output.

Conceptually, the MRPL represents the additional revenue that the firm can generate by adding one additional unit of labor recall that MPL is the additional output from the additional unit of labor. The MPL is generally decreasing: adding a th unit of labor will not increase output as much as adding a 99th. Since competitive industries are price takers and cannot change the price of output by changing their level of production, the MRPL curve will have the same downward slope as the MPL curve.

From the perspective of the firm, the MRPL is the marginal benefit to the firm of hiring an additional unit of labor. We know that a profit-maximizing firm will increase its factors of production until their marginal benefit is equal to the marginal cost.

Therefore, firms will continue to add labor hire workers until the MRPL equals the wage rate. Thus, workers earn a wage equal to the marginal revenue product of their labor.

Marginal Product and Wages : The graph shows that a factor of production — in our case, labor — has a fixed supply in the long run, so the wage rate is determined by the factor demand curve — in our case, the marginal revenue product of labor.

The intersection of vertical supply and the downward sloping demand gives the wage rate. As in all competitive markets, the equilibrium price and quantity of labor is determined by supply and demand. More hours worked earn higher incomes but necessitate a cut in the amount of other things workers enjoy such as going to movies, hanging out with friends, or sleeping.

The opportunity cost of working is leisure time and vis versa. Considering this tradeoff, workers collectively offer a set of labor to the market which economists call the supply of labor. To see how changes in wages affect the supply of labor, suppose wages rise. This increases the cost of leisure and causes the supply of labor to rise — this is the substitution effect , which states that as the relative price of one good increases, consumption of that good will decrease.

However, there is also an income effect — an increased wage means higher income, and since leisure is a normal good, the quantity of leisure demanded will go up. In general, at low wage levels the substitution effect dominates the income effect and higher wages cause an increase in the supply of labor. At high incomes, however, the negative income effect could offset the positive substitution effect and higher wage levels could actually cause labor to decrease.

This creates a supply curve that bends backwards, initially increasing with the wage rate but later decreasing. Backward Bending Supply : While normally hours of labor supplied will increase with the wage rate, the income effect may produce the opposite effect at high wage levels. People supply labor in order to increase their utility —just as they demand goods and services in order to increase their utility.

The supply curve for labor will shift in response to changes in the same factors that shift demand for goods and services.

These include changes in preferences, changes in income, changes in population, and changes in expectations. A change in preferences that causes people to prefer more leisure, for example, will shift the supply curve to the left, creating a lower level of employment and a higher wage rate.

An increase in the demand for labor will increase both the level of employment and the wage rate. The size of the mark-up will be bigger:.

Workers do not always seek to maximise wages — non-monetary rewards, such as job satisfaction may mean some workers choose a less well paid job which offers other rewards see notes on 3. Monopsony employers - Some employers may be the only, or dominant employer of a particular kind of labour.

For instance, the NHS employs most of the doctors and nurses in the U. For a profit maximising firm, the equilibrium level of employment is at a level where the marginal cost of labour is equal to the the marinal revenue product see notes on 3. In a perfectly competitive labour market, firms are price takers; they pay the same wage rate regardless of how much labour they employ. The supply of labour to the firm is a horizontal straight line at the market wage rate. This means the wage rate and maginal cost of labour are equal.

But a monopsony employer faces an upward sloping supply curve of labour; the firm is faced with the maket supply curve as it is the only employer.

To hire more workers it will have to offer a higher wage rate. This means that the marginal cost of labour is higher than the wage rate. The new wage rate will have to be paid to all workers, not just the new worker.

The market supply of labour is shown by S. If the industry consists of a sole employer, the demand curve is still the same assuming there is no re-organisation of production , and the market supply is still the same.

But the marginal cost, MC is now higher than the wage rate. Economic theory suggests that the union will be able to increase both wages and employment compared to labour market in which the monopsonist faces a non-unionised workforce. This is shown in Fig 4 below:. In a labour market where there is no union, the level of employment under monposony would be at A , and the wage rate would be at M.

Suppose a union is formed and negotiates a wage rate of U. The MC of labour will now be constant at U up to a level of employment of B. Beyond this level it could hire more wokers, but would have to offer a higher wage rate as shown by the supply curve of labour. So the proit maximising level of employment will be B. Increasing inequality of earnings — The gap in earnings between the highest and lowest paid has been getting biger in the U.

A number of factors have contributed to this:. Globalisation - see notes on 4. Jobs in call centres for instance have been outsourced to India.

Clothing factories in rich countries compete with much lower cost proucrs in Asia. Technology — Automation and I. Examples include banking, where many branches have closed, as customers use online banking and cash machines.

Employment in low skilled manuacturing and agriculture has also been affected by labour saving machinery. Driverless vehicles may eventually destroy the jobs of delivery van and taxi drivers. But new technology tends to create more demand for highly skilled workers who can operate new technology, particularly in the engineering and I.

New technology therefore tends to increase earnings for highly skilled workers relative to lower skilled workers. There is a growing concern that I. This includes the work of some health care professionals, for instance. Immigration — It is likely that increased immigration from Eastern Europe since , when a number of new countries joined the EU has put downward pressure on wages in some sectors, such as hospitality, agriculture and social care.

Immigration has inceased the labour supply to those industries. The overall effect on wages across the economy is hard to assess. Immigrants create demand for goods and services too, so generate demand for labour elsewhere.

Government policy — In the U. In the s the government took various measures that have restricted the power of trade unions to take industrial action, reducing their influence in wage bargaining. Since trade unions represented millions of lower paid workers, this has probably contributed to a relative decline in earnings for those affected.

However, the introduction of the National Minimum Wage in and the National Living Wage for over 25s in has improved the wages of the lowest paid. For instance women were not allowed to work in mines, on building sites, to drive lorries, fly aircraft or go to sea in the Royal Navy.

Women also faced outright discimination in pay levels, often being paid less compared with men doing the same or comparable jobs.

Equal pay and anti-discrimination legislation has gone some way to reducing the gender pay gap, but it still exists. A major reason for the continuing gender gap is that women still take the major responsibility for child care. This cookie is used to store the language preferences of a user to serve up content in that stored language the next time user visit the website. This cookie is set by Addthis.

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When supply and demand meet, the equilibrium wage rate is established. Long story short: the price of labor is determined in the free market just like every other price, by the intersection of supply and demand. But what happens if the equilibrium wage rate is less than the minimum wage? If you play around with your supply and demand curves, you'll see that an artificial wage floor should increase unemployment among low-wage workers.

That creates an interesting dilemma for policymakers, of course: the minimum wage helps those who have jobs that would otherwise pay less, of course, and as you'll see on the next page also has the effect of lifting wages even for non-minimum-wage workers. But that comes at the cost of increasing joblessness.