Monday, March 30, 2009

Why do wages rise?

I was reading the Wall Street Journal and I read an extremely interesting explanation about wages from Henry Hazlit's book, "Economics in one lesson". Greed, i.e. competition, is what makes wages rise. Generally speaking compensation is based on productivity, the more some one produces the more they get paid. The counter intuitive aspect of this is: why would you pay someone who is more productive not because they are any smarter or work any harder but press a button on some piece of machinery? It almost seems unfair that a guy who works for someone else should take advantage of the capital investment of their employer. That person didn't invest in any capital, they just sit there and utilize the machinery and tools given to them. Yet, these people make more money then those that don't have the capital to improve their productivity.

What is the most you are willing to pay someone? The right answer is that you are willing to pay them anything less than the revenue they generate. You won't pay them anymore money than they generate because you will go out of business, but anything less is acceptable. So the question is, in a competitive market what will that salary be? Well, it will tend to be just underneath the value added by that employee. Let's say you pay someone 1 dollar an hour and that person is generating 10 dollars an hour what will happen? A greedy entrepreneur will see the 9 dollars an hour in profit and say, hey I'll take 5 dollars a hour in profit. This will continue until the wages can't go any higher. The important thing to note is that the amount someone would be willing to pay is independent of how that revenue is generated. Some greedy guy is always out there willing to pay a button pusher if it makes him an acceptable profit.

4 comments:

Geoff said...

"A greedy entrepreneur will see the 9 dollars an hour in profit and say, hey I'll take 5 dollars in [sic] hour in profit. This will continue until the wages can't go any higher."

So, are you saying that the greedy entrepreneur will agree to pay 4 dollars in wages to hire that worker?

The whole point of this article seems to be that compensation will rise up the point of "break even" for the owner. I agree with that to some extent, but I would say in a competitive market there is also a force acting to keep wages from rising: prices.

Some greedy entrepreneur is going to enter the market by producing a similar good for a lower price. It seems to me that that would act as a sort of check on wages continuing to rise.

Consider outsourcing for example. Companies can pay customer service reps much less in India than they would have to pay for a worker in the US. That keeps wages lower.

To sum it up, it seems to me that while greed is what makes wages rise, it is also what checks the rise in wages.

Adam Freund said...

Good point. I would disagree that the greed of the owner is what checks the rise in wages, I would say your argument is that it is the greed of the consumer which checks both the owners profits and as a result the wages they can pay.

One interesting thing to think of is that in an indirect way either the owner keeping prices down or the owner raising wages is in a way the same thing. The worker reaps the benefit directly if his wage rises. If the price becomes lower then everyone reaps the benefit. The important point to me is that in neither situation is it possible for the owner to "exploit" the worker which is an argument against capitalism.

Geoff said...

"The right answer is that you are willing to pay them anything less than the revenue they generate." I find this idea interesting. I think your statement is true theoretically. However, there are only two situations under which I can see the owner paying a worker wages just below the revenue they are able to generate. First, if the demand for labor or a particular set of skills is so strong that the owner must pay high wages to attract qualified workers, or second, the owner's industry is so mature that his/her products are commodities with very, very slim profit margins. Neither of those situations seem ideal from a profit perspective.

So, it seems to me that the "spread" between what the owner pays the worker and the revenue the are able to generate is really a measure of the growth potential of the business. The longer they are able to keep the spread large, the more opportunity for profits.

However, the larger the spread, the more attractive the market looks to competitors. After all, they may be satisfied with 10% or 20% or lower profit margins than the owner. So it seems like the owner needs to balance the size of the spread to reap maximum profit for him/her self while at the same time reducing the attractiveness to other would-be competitors.

I suppose over time, the spread would naturally tend to narrow as wages increase and more competitors enter the market. But if I were analyzing a company for investment purposes, it seems like measuring this spread could be a useful input.

Adam Freund said...

That's a very good point. In my MBA classes we talk about differentiaion being necessary to make more than economic profits. Basically the spread you are referring to is a proxy for that differentiation.

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