Theories of Wage and Employment in The Labour Market

Lewis Morra

May 14, 2014

Labour Economics Research Paper

Throughout the years in our society, there have been many changes implemented in the ways in which producers and consumers govern themselves in our markets. From free slave labour, to relativized compensated wage labour, there have been numerous industrialized changes world wide. Wages and even money in general, has become something of vast importance each passing year and as a society, we have structured levels of methods devising how to acquire and diversify wealth in our economy in more ways than ever before. Fundamental structuring such as education and designative instructive courses have become not only beneficial, but necessary for people to gain entry in the labour market and surpass the boundaries of minimum wage lifestyles, which is to be discussed. Increasing levels of education and experience will increase possibilities, from productivity to return on investment, and will grant an employer reason to implement efficiency wages. These types of wages granted to higher skilled employees are necessary for a firm to prosper by means of; discouraging shirking (in other words making it more costly to be fired), encouraging worker loyalty to the company, raising group output standards and finally, raising morale in a workplace. With this being said, it is easily notable how higher wages can encourage one to be more efficient and allocate even minimal resources to achieve higher productivity in a company, but what about lower wages? A decrease in wages will do the exact opposite, and in close relation, wage deflation will prove how underpaying efficient workers can lead to consequences and downfalls in a firm. Wage deflation can be directly related to underpaying employees because it is a form of under compensation, whereas an employee by means of experience and training is worth more, but under valued. Wage deflation occurs when wage compensation to an employee is not kept up with economic inflation which usually occurs at times of stagnant economic times such as a recession or times of lack of economic growth (economic troughs in a business cycle graph).  Another instance wage deflation may occur is when a technology is introduced that could ultimately take over part of someones job. 

Technologies over the years through industrialization have been invented and implemented into our economy to push higher volumes of outputs in firms and decrease manufacturing and labour costs, so although this can be detrimental to an employee, it is deemed high regard for producers to implement such technologies. By means of advancements in technologies, firms are able to create product innovation and increase quantities, while simultaneously decreasing production costs. At this time, firms will see prosperous gains and higher Production Possibility Frontiers (PPFs), which is prevalent in our growing society. Producers are able to attain higher gains because these new technologies yield better techniques which in turn leads to higher obtained efficiency, also the decrease in labour costs may allow a firm to expand production, thus grow in a economy. With this being said, it can be noted that with the increase in implemented use of technology, producers now will see less need to hire more skilled workers and will be more influenced to hire cheaper labour such as minimum wage, unskilled labourers. 

 “In the past, and to some extent today, the means for living and for procuring the services of others was not primarily through a system of wage payment.” - Theory of Wages, Florence Peterson

The time where money was not a means of currency is over. One could in fact live and work without the process of money transaction by means of producing his/her own goods and commodity and even in a surplus to trade or barter, but since modern society is infested with greed and gluttony, making a living for the sake of survival has also become a notion not too popularized to this day, and this is why human capital strive to attain the highest amount of wealth and highest possible utility. As previously mentioned, there has to be diversity in an economy where a new idea of “class” is modernized, moulding a society into sections and creating division in inevitable. Diversity presents itself in the work force mainly as skilled and unskilled labour capital, and with the implemented new growth of firms via use of technology, a bigger diverse society can be witnessed as this phenomenon excels. Fewer people will control more wealth and more will be unskilled as this division widens with the emergence of a new aged competitive, capitalistic society.

“Wage theories in a noncompetitive economy, such as state capitalism or communal socialism, would of course be based upon entirely different concepts. In a “free” capitalistic economy, wages represent the payment of one of the factors involved in production. Since the problem turns on the question of the sharing of distribution of the goal income derived from productive enterprises, theories of wages cannot be dissociated from the other factors of production.” - Theory of Wages, Florence Peterson

It is now witnessed how an economy is governed by naturalistic ideologies to acquire wealth and obtain the highest value of commodity to match their “greedy” utility, but it is yet to be discussed how these values intertwine in a competitive society with further structure. Wage rates, experience, and employment are factors in determining division of labour and will soon be investigated. In a market where there are many firms to produce and many consumers to purchase, there are natural rules that govern methods to buy and sell. Natural rules such as the ones previously mentioned, where producers want to sell efficiently; and buyers want to buy efficiency, both in terms of saving money and gaining more. This makes for a competitive market where the supply of labour in terms of wages to produce and prices to sell are set by the economy. In contrast, the demand is set by the prices which are also set by the economy. This makes earning exceptional amounts of money and becoming very wealthy, more difficult. First, a topic of monopolies and monopsonies (monopoly for labour) can be discussed, whereas there are not many firms so the monopsonist will be the one to set the wage rate as he sees fit. There is a contrast for the many dissimilarities in this type of labour market, for instance in this market the supply of labour is not equal to the marginal cost of labour like it is in a perfectly competitive market, this is because to increase labour by 1 additional unit in a monopsony, the cost isn't just higher for the 1 extra unit of labour, but an additional increase in wage for the previous worker.   

In this type of situation where a monopsony is present, the producer of the firm will hire at MCL = MRPL, where the marginal cost of labour is equal to the marginal product of that additional unit of labour. This would not be the case in a competitive market, nor is the firm in this scenario paying the employee a wage rate of denoted MRPL(w), in this particular case the firm is hiring at Eq, but paying the employee a wage of Wq(w), since the labourer is willing to work for the said wage (Wq) on the labour supply average cost curve on the graph (ACL). The monopsonist is able to do this because even though the worker is valued more where MCL = MRPL, they are willing to work for a lesser wage. In relation to a perfectly competitive market where labour capital has a choice of where to work, a firm in perfect competition will hire where the demand for an additional worker is met by the supply in terms of average cost of labour - ACL = MRPL. At this intersection, wage rates and the quantity of labour employed are both higher than that of the scenario where monopsony was in effect. As can be shown, there is a vast difference in terms of wages and employment in perfect and imperfect labour markets. There exists no sensible relationship between a producer in a monopolistic or monopsonistic economy, and the quantity demanded of labour at the existing economic wage rate; this can be reassured noticing that the monopsonistic labour purchaser does not yield a short run labour demand curve. With this monopsony in place, it is possible to implement a minimum wage rate in such a scenario that a benefit to labourers in the firm and workers in the economy can be noted. In this case for example, a union minimum wage rate is denoted by “min w”, much above the monopsony wage Wq, and just above the competitive market equilibrium given by “comp w”. 

In this case, labour  supply denoted by C, exceeds that of the labour demanded on the MRPL schedule at point A. This makes the new average cost of labour curve, minWCACL, since the firm cannot hire below the minimum wage rate below point C.

Now that a brief description of wage rates in a monopsony verses a perfectly competitive market has been presented, it is viable to take note back to previous discussion on factors in determining labour and wages. It was a great man who quoted,

A man educated at the expense of much labour and time…may be compared to one…expensive machine…The work which he learns to perform…over and above the usual wages of common labour will replace the whole expense of his education. - Adam Smith

Adam Smith attests to previous notion that education is a form of investment in which labourers will expend time, resources and effort into to become more efficient, knowledgeable and more capable of commanding such jobs that requires more skill and in turn, will be compensated for such skills in the form of higher wages. This theory can be viewed evident in a “CobWeb” Model - initially originated by Nicholas Kaldor - where periodic fluctuations are represented on a graph to show future expectations with present determinants (such as levels of education and experience).   

As shown in the graph above in A, there are 2 demand curves for labour. First, a type of lesser skilled labour and another for higher skilled labour via education and training, represented by D1 and D2 respectively. To maximize efficiency and thus output in a firm, a company will demand higher skilled human capital to thrive. As shown above, to attain higher and more skilled human capital, that firm will have to pay a higher wage which can be shown by the vertical leap from W1 to W2 on graph A. The straight vertical leap from W1 to W2 can only be witnessed because there is a short run supply of labour denoted L on the graph as inelastic, and the reason for this is because in the short run, an operator of a firm cannot instantaneously gain extra human capital. In order for this to happen, it takes time and resources to train and hire more workers. It isn't until time passes in the long run where a change in the graph can be viewed, such as in graph B where we see a horizontal shift towards the long run supply curve S. This is only attainable because in the long run, an employer has the opportunity to train and hire new workers at that higher wage rate, which is why there is also a shift in quantity of labour supplied from L to L2. Further down the road, the company will likely operate in equilibrium whereas in this scenario, wages will decrease because workers are getting overpaid for D2 levels of skill, and at that slightly lower wage rate, less skilled labourers will be willing to work for lower wages - this will remain true until the demand for more skilled labour equals the long run supply.

To return to the relatable ideologies of Adam Smith, we can now hold true his notion that education is a form of investment in time, but now a new question will arise regarding the amount of time and when time invested into furthering education is too much time invested. Time is the most valuable resource an individual can possess, one may choose to allocate time as a resource in exchange for consumption or leisure, but cannot acquire additional time. This is because individuals have a life span, and are faced with decisions on how to spend their life span in the market, either in the labour force or not, employed or unemployed; and if unemployed, without a job but actively seeking work. Individuals are also faced with decisions prior to entering the labour force, such as how much time to allocate to developing skills via educational institutions and how much money to invest in it as well. These can be seen as direct costs, whereas indirect costs may refer to the opportunity costs of investing time into gaining experience, in other words the money forgone and unattained from entering the work force later instead of earning wages sooner in direct exchange for time spent. However to analyze this idea and see how much time an individual should spend in training, it is best to first witness how these costs are interpreted in the study of economics. In the graph below - presented by David Sapsford; professor of Economics, University of Lancaster - it is shown how an individual would undergo direct and indirect costs of expanding education to later on inherit the benefits.  

Prior to joining the labour force at age 21 on the graph, an individual would train from age 18 to 21, and incur costs equaling X and Y, where X is the opportunity cost foregone by wages he or she could have earned, had they entered the work force at age 18 and skipped education. The real  question would now be, how much time in terms of years would the labourer in this scenario have to work to make up for the direct and indirect costs of inheriting the benefits, Wt - Ws, in the labour market. An individual seeking to further education will incur direct and indirect loss in terms of costs as indicated in the graph above, but what is not shown is the years of education relating to marginal costs and marginal benefits. In deciding how many years of time to allocate to become more skilled and ultimately earn a higher wage rate in the labour force, an individual will gain education where the extra benefit, or marginal benefit of each extra year of studying (MB), will equal the extra costs, or marginal costs of each extra year (MC). In this case, marginal benefit is viewed in terms of the marginal amount of wage rate annually that person will make in the work force, similarly the marginal cost is the marginal time, indirect and direct marginal costs combined, that the person will lose annually. With this said, it is apparent that the marginal costs of education will be an upward sloping curve, and the marginal benefits of education will be downward sloping on a graph with the value of marginal benefits and marginal costs on the Y-axis, and years of education on the X-axis. This is because as people tend to stay in the education system longer, education becomes more expensive with each passing year, from high school to undergraduate studies, and post graduate studies respectively. With this being said, it is also apparent that the benefits of staying in the education system longer possess diminishing returns since the costs of gains of having more education will start to outweigh the benefits. Another way of looking at this is to view the combined marginal costs and marginal benefits in terms of “internal rate of return”, and compare it to the market interest rates (money that could be spent earning bank interest as an opportunity cost). In this case, it is best for an individual to achieve years of education at the point where there internal rate of return equals the market interest rate. A perfect brief description of this optimal selection can be read in the course text on page 248,

“Individuals choose the human capital investment that maximizes the net present value of lifetime earnings…Alternatively, the individual could calculate the implicit (or internal) rate of return i for each level of education, corresponding to the discount rate that yields a net present value of zero for the investment…the individual should invest until the internal rate of return equals the opportunity cost of the investment, given by the interest rate.” - Labor Market Economics, pg248

In certain circumstances, there lies a scenario in which the employer will aide in providing financial support for the direct costs of increasing skill in the firm while the employee is hired. For example, a chartered financial analyst working for a federal corporation will have to achieve his or her CFA designative courses for the assigned position. If at the time of hire or even afterwards, the employer notices only a first level designation, that employer will pay half of the direct cost for the new employee to study their level 2 and eventually level 3 designations to increase skill and be a more efficient worker in the firm. In the long run, both the employee and employer will share benefits in this cooperation, the employer will gain more skill from the employee without having to hire additional labour, and the employee will enjoy a higher wage rate without having to get another job or twilit to perhaps generate the same income. In a separate case, it has been shown in times where an individual after allocating time and resources to expand their possibilities frontier, will willingly remain unemployed. There are more than a few reasons for this outcome to arise. This type of unemployment - also called “voluntary unemployment” - remains viable in situations where the skilled labourer deems him or herself more valuable, and purposely remains unemployed in search for a higher wage paying position rather than to settle with what is currently being offered at the time. A similar yet contrasted experience can be noticed in cases where the ruling for a particular position in terms of wages offered, is higher than the economic set equilibrium wage rate. In this case there will be an excess supply of labour in the market for such a particular position and an over labour demand - this is the case where an individual in the labour force will be involuntarily unemployed. In this case, the skilled labourer will want the job offered and attempt to gain the position, but since there is an under demand for the job because the wages are set higher than equilibrium and there is an over supply for the same reason, this individual’s chances of getting that job are smaller. There lies a theory connected to this idea that participation in the labour force will increase in a given economy, when unemployment rates are on the rise. For example, in a family where only the man of the household is working, he might experience a time in his life where hours are cut or he is laid off or even fired from his job. At this point in time to supplement income for the family, a family member such as the wife or child may join the labour force to help pay for bills and increase overall net income for the family, which is known as the “added worker hypothesis”. This also holds true for a circumstance of discouraged workers. In times where there is a decline in GDP in an economy and wealth is stagnant, jobs become harder to obtain and the supply of labour eventual exceeds the demand. An individual striving to search for a job may start to settle in the short run when seeking employment, and take a job he or she is overqualified for with a lower wage rate, and if the individual does not settle, that person might become discouraged and want to leave the workforce altogether and stop any attempts in searching for a job - which is known in economics at the discouraged worker hypothesis. This directly impacts a survey of unemployment, because a new term “hidden unemployment” would be used to describe such human characteristics in an economy. To describe this more clearly, hidden unemployment refers to those who are not necessarily in the labour force, but would be if finding a job would be easier or more readily obtainable at the time.  

Theories on how to allocate time to train for a job and participate in the labour market have been discussed; decisions on weather to join the labour market or not have also been addressed, one subject is to be noted on what decisions to make as an employee once a job has been obtained. As mentioned earlier, an employee in the labour market is faced with choices, and the biggest choice employees make when in the labour force, is how to allocate time as vital resource (so many hours to work), which in turn will lead to income. In economic theory, it is proper to state first that all income (again theoretically) will be spent on consumption in the economy (for cyclical purposes), the result: the Income-Leisure model. This model directly shows how an employee as a consumer in the market, would make choices by use of personal utility, and would directly compare amount of personal consumption to personal leisure. This model becomes very useful for employers because it demonstrates how changes in wealth, determine the cause and effect reaction of an employee’s optimal choices in allocating time. In this drawn graph below, it can be shown how an individual might allocate time to leisure or income (consumption) and how increases in wage might alter preference of consumption of good and leisure.

The consumer has initial choices along X1 and Y1 to work more and have less leisure. In this case, at a wage rate -Y1/X1, the consumer has choices to either spend all his his or her time working and is then able to achieve Y1 amount of income for consumption, or this person may not work at all and allocate all of his or her time doing leisurely activities and producing 0 income at X1 amount of leisure. Since the employee has an indifference curve pertaining to the X1,Y1 income leisure curve, this person will operate at optimal point A and work X1-T1 hours and make YA income. This individual will operate where the wage rate -Y1/X1 equals the slope of his/her indifference curve at point A, which is his individual marginal rate of substitution. An employee in the labour force may also have preferences as noted earlier, these preferences are followed by effects from the choices the labourer may have, in this case it is evident to study the case of a increase in wage and the following income and substitution effects that may arise from it. In the graph above, the slope increase from Y1,X1 to X1, Y2, is displayed as a wage increase (higher negative slope). With a higher wage rate, a consumer is now able to achieve a higher income, thus is also able to spend more money and ultimately consume more goods (since in this theoretical scenario, all income must lead to consumption). With the ability to consume more goods, a consumer will face 2 decisions of wether to work more and take advantage of the higher wage rate, or work less because he/she is able to still consume the same or even more, also with more leisure. 

When the X1,Y1 curve becomes more steep on the graph with the higher wage rate, and becomes X1,Y2, a steeper curve implies a bigger loss in each increment of income represented by the Y-axis when moving down the curve for each marginal increment gained in leisure represented by the X-axis. In said situation, a substitution effect is noted and the consumer will now reside at point C on the curve, with less leisure X1-T0, and more income because consumption is now valued to the consumer more. The second choice a consumer may make is to work less since he or she will still remain more satisfied because they able to afford more goods without having to work more and even working less. As we can see on the graph, this consumer values leisure higher and will not work more even with a higher wage rate - point denoted by B on the graph.

Many topics have been addressed briefly in terms of different theories witnessed and implemented in various economics. From the wages an employer might choose to hire at or grant such as efficiency wages, to market wages such as in competitive markets models and how wage deflation can alter the market. Industrialization and how the implementation of new technologies of various sorts can shape the decisions firms will make and also change the structure, allowing higher production of commodity and the ability to hire less skilled workers, and still be more efficient. From this theory stemmed discussion on the birth of capitalism and how society has reached an age where money is prevalent and making money for the sake of living has become an idea of the past. Following this, the realization that an economy with a monopolistic and/or monopsonistic business will price discriminate and hire under the valued wage rate to save money and raise utility which is a motion of a capitalistic firm, which also in tern led for the emergence of discouraged labour theories. These stem from firms not hiring at the proper valued wage rates, which will lead to individuals actively seeking jobs, feeling discouraged and under valued in the economy, and also reside to hidden unemployment status. Theories of education were noted where an individual in would have to make choices prior to entering the labour market, these in regards to education and the length of time, when and for how long to gain skill in educational institutions, and finally, touched on the topic of how to allocate time as a resource once employed in the labour market. There are many theories regarding wage and employment in the labour market, these investigated are only a few intertwined with each other, some never changing as they portray the foundational structure of human ideology, and some changing with the always-changing economy.

Work Cited

-Benjamin, Dwayne and Morley Gunderson. Labour Merket Economics, Theory, Evidence, and Policy in Canada, seventh edition. Library and Archives Canada Cataloguing in Publication. 2012

-R. Varian, Hal. Intermediate Microeconomics, a Modern Approach, eight edition. Jack Repcheck. W.W. Norton & Company. New York. London. 2010

-E. Kaufman, Bruce. The Economics of Labour Markets, third edition. Jan Richardson, Karen Vertovec. 1991

-Sapsford, David and Zafiris Tzannatos. The Economics of the Labour Market. St. Martin’s Press New York. 1993

-Krader, Lawrence. Labor & Value. Cyril Levitt & Rod Hay. Peter Lang Publishing, New York. 2003

-Peterson, Florence. Survey of Labour Economics. Revised Edition. Harper & Brothers Publishers New York. 1951

-Kay, Geoffrey. The Economic Theory of Working Class. The Macmillan Press Ltd. 1979

-Krimpas, G. E. Labour Input and the Theory of the Labour Market. Gerald Duckworth & Co. Ltd. 1975

Also used as reference;

www.economics.about.com - Efficiency Wages

https://cstl-hcb.semo.edu - business cycle graph

https://tutor2u.net/economics - Monopsony information and graph aide

https://www.econ.ucsb.edu - Leisure Income Graph Aide

https://www.investopedia.com/articles/economics - CobWeb Graph