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Wages are remuneration for labor services, in the form of either cash or some other mechanism of compensation. Wages have been the subject of extensive empirical and theoretical inquiry, the focus of which has included causes and consequences of wage variation, implications of evolving labor market conditions, and the effects of wage increases on productivity and growth. Generally, these studies approach such questions through the prism of two alternative labor market circumstances: perfectly competitive markets, in which consumers and producers have no market power to affect prices, and imperfectly competitive markets.

The Labor Market Under Perfect Competition

Traditionally, economic analysis is predicated on the assumption that labor markets are perfectly competitive. For this to be reasonable, three criteria must hold: There must be no barriers to entry; agents must have complete information; firm and labor mobility must be costless. When these conditions obtain, wage rates of a given quality are determined by the intersection of the labor supply and demand curves. The labor demand curve reflects the marginal productivity of labor confronting profit-maximizing firms. The labor supply curve reveals the willingness of utility-maximizing individuals to supply labor at each conceivable wage. The intersection of these two curves determines the market clearing wage rate, at which all persons willing and able to work will find employment. In this framework, the wage rate is a market price that effectively allocates labor across alternative (and competing) uses.

One vein of the empirical work mentioned above is essentially rooted in this perfectly competitive framework. For instance, there is a tradition of fairly straightforward examination of inter-temporal wage patterns implicitly interpreted through the lens of perfect competition. Katz and Autor (1999) examine longitudinal wage data in the United States, revealing several interesting patterns. The ratio of wages of those in the ninetieth percentile of workers to those in the tenth percentile has grown substantially in recent decades. Large wage disparities have also been detected by education and experience levels. Nonetheless, wage gaps between white and black males and males and females overall have narrowed.

There is, however, no consensus regarding the causes of these structural changes. An often-cited theory explains wage differentials as a result of investments in human capital (e.g., through education, health, or training). Becker (1964) formalized this idea by demonstrating that greater human capital expenditures could account for empirically observed patterns of wage variation via their impact on the marginal revenue product of labor. This theory received empirical support from Mincer (1974), whose estimates of the returns to education were positive and increasingly significant with controls for years of experience in the labor market.

Numerous studies question this explanation of observed wage differences. For instance, Pritchett (2001) shows that education has contributed very little to economic growth. He speculates that, among other possibilities, this might reflect the irrelevance of knowledge transmitted through formal schooling (in terms of the skills actually required in the workplace). From a slightly different perspective, some (e.g., Spence [1974]) have argued that education contributes little directly to labor market productivity, but instead serves as a kind of signal for ability that allows employers to sort high and low ability workers.

Another avenue for wage variation generally approached through the framework of perfect competition is immigration. LaLonde and Topel (1991) consider the impact of newly arrived immigrants on the wages of workers born in the United States as well as those who had immigrated to the United States earlier. They find that immigration has a negative, but small, impact on the wages of earlier immigrants and native-born workers who represent close substitutes (i.e., low skilled workers) for these more recent arrivals. This relationship attenuates as the tenure of earlier immigrants in the United States increases. Others (e.g., Borjas [2003]) have disputed these findings, claiming that they stem from the failure to control for the migration of native-born Americans to other cities and states.

A Departure From A Perfectly Competitive Labor Market

The other major theoretical and empirical tradition focuses on possible market failure resulting in involuntary unemployment (a situation where workers willing to work at the prevailing market wage rate cannot find employment). Efforts to explain such failures have centered on two major theoretical possibilities: market failure rooted in the purposeful decisions of optimizing agents and failure as a consequence of government intervention.

The former possibility (failure stemming from the actions of optimizing agents) has received considerable research attention. To begin with, there is the obvious potential for a “menu costs” type situation: Firms may resist adjusting wages to a new equilibrium level if the transaction costs associated with doing so are sufficiently high. Another possibility that has attracted more interest is commonly referred to as “efficiency wages” (e.g., Akerlof and Yellen [1986]). This is the idea that wages might be set above market equilibrium for the purpose of inducing higher worker productivity and efficiency.

Several specific motivations for efficiency wages have been suggested. First, they might reduce shirking and increase the financial penalty associated with termination. Shapiro and Stiglitz (1984) demonstrate that in the face of limited monitoring resources firms are willing to pay efficiency wages for these reasons. Efficiency wages might also lessen turnover costs by rendering workers less likely to quit their jobs (more experienced workers tend to be more productive than new employees, whose training can also be costly). Particularly in the setting of lower income countries, higher wages can improve the health and overall well-being of workers (through greater food and health consumption), potentially raising their productivity. Finally, efficiency wages can help firms avoid adverse selection by encouraging more skilled (and thus more productive) workers to apply for jobs.

Another potential source of market failure comes from the timing of wage contracts. In essence, contracts offer a specified wage payment over some fixed interval of time during which there might be shifts in labor supply or demand (and hence in the fundamental equilibrium wage that would prevail in an unfettered market). However, such contractual agreements can prevent adjustment in wages toward these new equilibrium conditions (a situation referred to as “wage stickiness”).

State intervention is another major reason that equilibrium conditions in the labor market may fail to obtain. For instance, a legally mandated minimum wage (a kind of price floor) may result in labor market disequilibrium if that minimum wage level is binding in the sense that it exceeds the equilibrium level that would emerge in its absence. Most empirical and theoretical work on the subject suggests that minimum wages that are binding in this sense yield, ceteris paribus, lower employment levels. However, a few studies (e.g., Card and Krueger [1994]) have received a great deal of attention for reaching the opposite conclusion. Card and Krueger (1994) examine the effects of an April 1992 minimum wage increase (from $4.25 to $5.05 an hour) by exploiting the fact that the increase was implemented earlier in some states than others. Employment levels before and after the change showed no signs of the decline anticipated in the face of an increase in the minimum wage: Employment levels actually increased. However, Card and Krueger (1994) have received a great deal of methodological criticism.

Bibliography:

Akerlof, George A., and Janet L. Yellen, eds. 1986. Efficiency Wage Models of the Labor Market. Cambridge, U.K. and New York: Cambridge University Press.
Becker, Gary. 1964. Human Capital: A Theoretical and Empirical Analysis, with Special Reference to Education. New York: National Bureau of Economic Research.
Borjas, George. 2003. The Labor Demand Curve is Downward Sloping: Reexamining the Impact of Immigration on the Labor Market. Quarterly Journal of Economics 118 (4): 1335–1374.
Card, David, and Alan Krueger. 1994. Minimum Wages and Unemployment: A Case Study of the Fast Food Industry in New Jersey and Pennsylvania. American Economic Review 84 (4): 772–793.
Katz, Lawrence F., and David H. Autor. 1999. Changes in the Wage Structure and Earnings Inequality. In Handbook of Labor Economics, vol. 3a, eds. Orley Ashenfelter and David Card, 1463–1555. Amsterdam: North-Holland.
http://economics.harvard.edu/faculty/katz/papers.html.
LaLonde, Robert, and Robert Topel. 1991. Labor Market Adjustments to Increased Immigration. In Immigration, Trade, and the Labor Market, 167–199. Eds. John Abowd and Richard Freeman. Chicago: University of Chicago Press.
Mincer, Jacob. 1974. Schooling, Experience, and Earnings. New York: National Bureau of Economic Research.
Pritchett, Lant. 2001. Where Has All the Education Gone? The World Bank Economic Review 15 (3): 367–391.
Shapiro, Carl, and Joseph Stiglitz. 1984. Equilibrium Unemployment as a Worker Discipline Device. American Economic Review 74 (3): 433–444.
Spence, A. Michael. 1974. Market Signaling: Informational Transfer in Hiring and Related Screening Processes. Cambridge, MA: Harvard University Press.