Economic Theory of Wage Rates

A job provides a number of benefits to the worker. A job provides an opportunity to contribute to the well-being of society, as suggested by DeKoster (1982), “… work is the form in which we make ourselves useful to others.”⁶ A job also provides the means to meet one’s own material needs and to care for one’s family, but work provides benefits beyond remuneration to workers. A job may be used to develop skills that enable a worker to find a more remunerative job in the future. A part-time job can be used by a young person to help pay for his or her higher education. A retired person may want to stay active and desire a job for the social benefits rather than for the monetary reward.

As a result, workers may be best served by some jobs whose earnings are relatively low because the jobs provide attractive nonmonetary benefits. Not every job must provide remuneration sufficient to support a family for a labor market to be considered just. In fact, in a dynamic economic setting, it is probable that a society in which every job provides remuneration sufficient to support a family would be grossly inferior to a society in which many jobs were low paying, temporary, or part-time. The key is to focus on what job seekers desire from a job. For many, the wage rate is critical, but for some people, other dimensions of the job are more important.

Economists use the tools of supply and demand to describe the determination of wages and to analyze other aspects of labor markets. Employers “demand” labor because laborers are needed to work with other productive resources to produce a product or service that is sold to others. It is the revenue from the sales of the product or service that allows the owners of the productive resources, including labor, to be paid for their services provided. If no one wants the product or service provided by the employer, or if the price charged is too high, the employer will not be able to stay in business and the resources employed will be released.

The price that an employer is willing and able to pay for a resource is related to the resource’s contribution to the revenues of the firm. The resource’s contribution is related to the productivity of the resource and the price that the firm receives for selling its good or service. That is, the remuneration received by the owner of a resource is directly related to the productivity of the resource. This applies to land, raw materials, and capital, as well as to labor. The more productive that workers are, the greater the remuneration that workers will receive.

For the purposes of this article, the more important determinants of labor productivity, and hence, of labor’s remuneration, are the quantity and quality of the other resources employed along with labor. A farm laborer can produce more working on high quality land than on poor quality land. Similarly, a farm laborer can produce more working with a tractor than with a mule. We concentrate on the importance of capital, since capital affects both agricultural and nonagricultural workers.

Capital can be divided into two broad categories—physical capital and human capital. The essence of capital is that it is a resource produced to increase future production. Physical capital includes the tools, equipment, and factories used to make goods and services. Human capital refers to the training of workers that makes them more productive. This training can be through formal means such as school and vocational training programs and through informal means such as on-the-job training and work experience. On-the-job training can be general training or specific training, where general training refers to the acquisition of skills that are of value in other firms as well, while specific training involves the acquisition of skills that are of value to the firm that employs and trains the worker alone.

In a similar fashion, experience can be divided into two types—general experience that increases the productivity of the worker generally, and firm-specific human capital that increases the worker’s productivity as long as the worker continues to work for the same firm.⁷ The greater the human capital of a worker, other things being equal, the more productive the worker can be and the greater the remuneration that the worker is likely to receive. The decision of how much formal human capital to acquire is made by the worker.

A major factor determining the remuneration of a worker is the level of formal schooling that the worker has obtained. There is an opportunity cost for continuing another year of education—the lost earnings that the young person could make by working rather than by attending school. On the one hand, the availability of relatively low-paying, part-time jobs reduces the opportunity cost of attending school by providing some funds for the young person or for his or her family. On the other hand, the opportunity cost of another year of education increases with each additional year of schooling, since the potential earnings increase as education levels increase. Economic theory predicts that a person is more likely to invest in an additional year of schooling if the following factors are present: (1) the household is forward-looking, (2) the cost of another year of school is relatively low, and (3) an additional year of education is likely to provide a greater return in terms of future earnings and benefits. Given these conditions, then, the worker faces a trade-off—additional schooling that increases productivity that will increase future earnings; but, to acquire additional schooling, the worker must forego current income.

We conflate two models that economists use to analyze the decisions that people make concerning the supply of their labor services—the labor-leisure trade-off model and the household production model. We provide only an outline of these models; further details can be found in any labor economics textbook. People have three broad uses for their time—work for pay in the marketplace, work at home for no pay (meal preparation, child-rearing, home maintenance, and so forth), and leisure activities (sleeping, reading, entertainment, hobbies, church activities, and so forth). Work for pay provides the income needed to pay for the leisure activities and to pay for many of the inputs used in household production. The opportunity cost of an hour spent in either leisure or in household production is the income that could have been earned had the person worked in the marketplace; that is, the wage rate. A higher wage increases the opportunity cost of both leisure and household production. The likely response to a higher wage is to work more hours, thereby reducing the hours allocated to either leisure or to household production.

One trade-off in response to a higher wage made by many people is to engage in less household production and to purchase items in the marketplace. Examples include eating out instead of preparing meals at home; putting children into childcare facilities; or hiring a painter instead of painting the house oneself. For a single adult, the individual makes the decisions, but married couples usually make the decisions jointly. Older children may also be involved in the decision-making process, especially regarding part-time or summer jobs that they may obtain.

Drawing together the several strands of economic theory above, we can make the following statements concerning labor markets in competitive situations.

How would a public policy of a minimum or living wage affect the decisions of households and affect the opportunities that workers face? A living wage is essentially a minimum wage put at a higher level than is typical. We will use minimum wage in our discussion, but the discussion is applicable to living wage as well. Some type of living wage would affect younger, lower-skilled workers the most. The greater the mandated minimum wage, the more people who would be affected. Clearly, those who keep their jobs and are able to maintain the same number of hours would benefit, but there would be many who would be adversely affected. Workers who are unproductive, either because of low levels of education or lack of experience, would find it difficult to obtain or keep a job.

The higher minimum wage would also influence decisions concerning how much schooling to obtain. The opportunity cost of another year of schooling for those workers who would be able to find work would increase. This, on the one hand, might induce some to quit school earlier than they otherwise would. On the other hand, there might be some who would not be able to find work and who would remain in school longer. Unfortunately, the decision to stay in school longer may also be affected by the income status of the household. Those from poorer households might find it more difficult to stay in school when the schooling involves cash outflows for tuition and supplies, as well as foregone income that might be needed by their families. The magnitudes of these effects cannot be determined a priori but would have to be estimated empirically.

There is a long-term problem that the living wage could generate. As noted earlier, an important source of human capital development is work experience. As will be seen in the next section, wages increase substantially with experience. Obviously, the acquisition of experience can only take place when a person works at a job. If the higher minimum wage prevents the least-skilled from obtaining jobs, it prevents them from obtaining experience that will enhance their skills and their future earnings. Ultimately, such individuals may be those who live continuously at the economic margins of society and even fail to get counted in unemployment statistics because they have given up looking for work. Again, the magnitude of this problem cannot be known a priori but would certainly be greater because of the larger difference between the minimum wage and the market wage.