Wage Determination Research Paper

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Wage determination refers to the market process that establishes the amount a firm pays a worker for a unit of time. A market exists when there is demand for and supply of a product. In the case of the labor market, firms demand individuals’ time as an input for production, and workers supply it. The nature of the labor market, including the number of firms and special qualities of workers, influences the wage determination process. Other social institutions such as the government and interactions between individuals, including those characterized by racism and sexism, also influence payments made to workers. This research paper discusses the basic process of wage determination along with the influences of market structure, government regulation, and other social interactions on it.



One reason wage determination receives broad attention among economists is that payments to labor constitute roughly 70% of the gross domestic product of every industrialized country. Most societies would like to put government policies in place to positively influence wage growth because, in aggregate, what people can earn relates directly to the material well-being of a country; however, this requires an understanding of what factors influence the level and growth of wages over time. Perhaps the most important determinant of wage rates is the level of education a person receives; however, theory indicates that general education will have a different impact on labor markets than specific training related to one industry or occupation. Governments attempt to directly affect the mix of general and specific skills among members of the labor force.

Thus, studies of wage determination relate directly to choices of broad social policies aimed at influencing individual and social welfare.

Another reason this topic receives substantial attention is that many societies have concluded that payments in the labor market should be determined by individual productivity and not by such factors as gender or race. Laws prohibiting these discriminatory practices reflect this social judgment. Studies of differences in wage rates for people who have the same qualifications but are not of the same gender or race seek to gauge the extent of discrimination in the labor market.

In discussing wage determination, it is important to understand what the term wage means. A wage rate is a payment from a firm to a worker for an increment of time. Most commonly, a wage rate is a payment for an hour of effort. However, the term, at times, can capture weekly, monthly, or annual pay. Restricting wages to reflect money paid to a worker for a defined period of effort isolates the payment from its interaction with hours of work in determining earnings, which is a separate concept. Examining the simultaneous determination of the hours individuals choose to work given the wage rate they receive is a standard topic within labor economics; however, it is beyond the purposes of this research paper.

This research paper first discusses how the structure of the labor market determines wages. This section emphasizes that the number of firms demanding labor significantly alters the wages workers receive in the market. It also discusses the role of labor unions relative to large employers.

The research paper then proceeds to discuss how investments in human capital in the form of general education and on-the-job training alter the wage a worker receives. The discussion then moves on to consider different theories of how wages change over the typical person’s lifetime. The next major topic is discrimination’s affect on wage determination. Finally, the research paper discusses the role of government in setting boundaries on market outcomes, followed by a brief discussion of policy implications and directions for future research.

Market Structure and Wage Determination

This section provides an explanation of how the structure of the labor market affects wages. The discussion begins with a review of how wages are set in a perfectly competitive labor market. One of the most important characteristics of competitive markets is that there are many firms competing for workers’ services. When this condition is not present, employers do not face competition for employees and have more freedom to set wages. At the extreme, there is only one firm seeking to hire workers. Economists refer to this type of market as monopsonistic. To emphasize the importance of market structure, this section explores the differences between monopsony and competitive markets. The section concludes by discussing how labor unions can counteract the market impacts of large employers as well as other effects attributed to them.

Wage Determination in Perfect Competition

Supply and demand characterize every economic market. Market supply is a summary of the total quantity of a good available at different prices. Market demand is a summary of the willingness to purchase at different prices.

In the case of the labor market, individuals supply, and firms demand, time. Individuals expect payment for their time, and they must decide, given their tastes and other sources of income available to them, how many hours they would be willing to provide at different wage rates. Summed across all workers, this linkage between the differential willingness of workers to provide time to the market as wage rates vary determines aggregate supply in the labor market, the total amount of labor available at different wages. Generally, workers are willing to provide more hours of their time to employers when wage rates are higher. Therefore, aggregate supply increases with the wage rate.

Demand for labor arises from the usefulness of workers to individual firms. Firms require labor to produce goods, and the dollar amount of total production associated with each additional worker is his or her value to the firm. Firms pay for additional labor as long as the dollar value of the additional productivity of another worker exceeds the wage paid for that person’s time. As long as the dollar value of the productivity of more labor exceeds the required payment, the firm’s profits expand, thus giving it an incentive to hire more. For a given type of labor, summing the demand across firms determines at different wage rates how much labor is used in total. If the wage rate is high, firms hire fewer workers and if low, they use more labor. Therefore, the demand for labor expands as wage rates fall.

Equilibrium in a perfectly competitive market occurs when the quantities of aggregate labor supply and demand are equal. Because the wage rate determines the quantity of labor supplied and demanded, the wage that prevails in a competitive market is such that the number of individuals willing to work equals the number of workers firms wish to hire. Thus, the interactions of aggregate demand and supply determine the market wage rate. This implies that firms pay the same wage rate to all workers. When economists speak of wage determination, at the most basic level, this is the rate of pay for a unit of labor determined by the interaction of market demand and supply.

For this theory to be operational, many assumptions must hold. First, the basic theory applies to one uniform type (homogenous) of labor. The theoretical model also assumes that there are many workers. Therefore, firms can hire as much labor as they would like at the prevailing wage. Theory also assumes that there are many employers competing for the time of the workers and that each firm is small relative to the market. These assumptions imply that neither a single worker nor a single firm has influence to negotiate for higher or lower wages. This is important because it means that if one employer tries to underpay workers relative to the going wage rate, workers can turn to other firms for employment. Free mobility of workers across many employers helps maintain the wage rate in the perfectly competitive model. The equilibrium wage in a perfectly competitive market is known as the competitive wage rate.

When any one of these assumptions fails, alternative market structures arise. Because the assumption that fails is associated with a competitive market, it is a case of market failure because it represents a departure from perfect competition. To illustrate this point, the next section considers the case of a market with one employer, monopsony.

Wage Determination on Monopsony Markets

The difference between a monopsonistic labor market and a perfectly competitive one is that under monopsony there is only one firm, the monopsonist. One assumption of a competitive market is that all firms are relatively small so that no single employer has influence over the competitive wage. However, if there is only one employer, then hiring decisions of the firm determine the wage paid to workers.

In this market, one firm determines the amount of labor used. As the firm expands its use of labor, it will have to pay a higher wage rate in order to make more workers willing to supply their time. Assuming the firm pays all equivalent workers the same pay, when it hires one new person, it must raise the pay rate of all current employees by an amount equal to the difference between the wage they were formerly paid and the new, higher one. Correspondingly, the firm views the additional cost of each individual worker hired as being far higher than what it might expect to pay one more person. This consideration leads the firm to hire fewer workers than would be employed in a competitive market. Because the firm uses less labor than would be employed in a competitive market and it can attract smaller amounts of labor at a lower wage rate, workers receive less pay than they would if many employers were active in the market. The result of having one firm hire all workers is lower pay and less employment than would be observed in a competitive labor market.

Wage Determination and Labor Unions

Economists initially developed the monopsony model to explain one-company towns that characterized industries like mining (Pencavel, 1991). A company might locate an iron ore deposit and purchase the rights to it, and as it organized the extraction process, it would be the only firm to hire miners at that location. Individuals viewed these firms as paying workers too little and working them too hard, which is consistent with the general outcomes of the theoretical model. In contemporary markets, economists use monopsony to describe hiring for hospitals in towns where there are no competitors, as well as professional sports where a single league employs all players.

Labor unions have always formed to enable workers to bargain more effectively with very large employers. Unions such as the United Mine Workers and the National Football League Players Association formed to raise more effectively worker concerns with employers than a single individual could. To be most effective, unions must organize the relevant pool of labor for an employer so that they can credibly threaten to disrupt business if the employer does not address workers’ concerns.

By organizing workers for an industry, unions have the ability to determine the amount of labor supplied to a firm at a given wage rate. In the monopsony model, a firm employs fewer workers because the cost of hiring an additional worker is larger than in a competitive market. Unions have the ability to set a uniform wage rate equal to what it would be in a competitive market through bargaining, and this can potentially raise both wage rates and employment back to the competitive level.

These positive views of unions are tempered by the observation that as workers vote on contracts, older workers are protected under union rules by seniority from being fired and are thus more likely to support demands and vote for pay packages that set wages above the level that might exist in a competitive market. To the extent that this is true, because the demand for labor declines as wages rise, this will reduce employment to below the level expected in a competitive market.

Unions receive a great deal of scrutiny for their impact on reducing the competitiveness of firms. If unions raise wages above levels observed in nonunion enterprises, then they arguably place the firm at a price disadvantage unless the higher cost is justified by increased productivity. Only 15% of all full-time workers over the age of 25 belonged to a union in 2000. By 2007, this percentage declined to 13.3% among all workers and was less than 10% among private sector employees. Because of this limited coverage, unions have less of a role in wage determination in contemporary labor markets than in times past. See William Dickens and Jonathan Leonard (1985) for an analysis of the determinants of the decline in union membership.

Wage Determination and Human Capital Acquisition

The previous section emphasized how market structure and worker responses to it affect wage determination. Rather than acting collectively, workers may make individual efforts to raise their rate of pay by investing in themselves to increase their productivity. Early work by Gary Becker (1962) and Jacob Mincer (1974) first conceptualized the idea that individuals may invest in themselves, hoping to recoup that expense through increases in their rate of pay. Thus, individuals may choose to invest in their human capital much as firms do for physical machinery.

Although most people think of investments in human capital as originating from the individual, firms have an incentive to invest in workers when this helps tie workers to them. Thus, the basic theory distinguishes between general skills that are transferable across firms and specific skills that raise productivity only for a specific employer. When skills are transferable to other firms, employers will not finance their acquisition. If skills are specific to a single employer, then firms should finance their acquisition.

The discussion here proceeds assuming that formal education leads to the formation of general skills that are transportable across employers. The reader should bear in mind that firms do have an incentive in some circumstances to invest in formal education.

Wage Determination and Formal Education

Education increases worker productivity. Because increased productivity brings value to the firm, education should increase the pay an individual receives. In deciding whether to pursue a course of education, such as a bachelor’s degree, an individual must examine not only the short-term earnings impact, but also the long-term effect of education on earnings. If the person is going to pursue a degree at a university, then most of the costs will occur in the early years and increased earnings will come later. So the individual should consider what the total stream of earnings from the additional education would be over his or her lifetime in current dollars. The individual must also consider what earnings would be in current dollars over a lifetime without the investment. By making a direct comparison of the earnings paths with and without the additional investment in terms of current dollars, individuals can calculate the rate of return that would occur if they spend money on raising their education level. Because individuals can invest their money elsewhere, a rational person should compare the rate of return from pursuing education to possible returns from alternative investments. Individuals will pursue education as long as the rate of return on that investment is at least as large as from other opportunities.

Becker (1962) also outlined two major factors thought to impact individual investments in education. The first is ability. If people differ in their ability to process information, then when exposed to the same material, they will carry away different levels of comprehension and effectiveness in transforming the information into productive workplace skills. Individuals should consider their ability levels as they make decisions about how much education to pursue. Students receive a considerable amount of information on their academic ability. Grades and standardized tests are routine. Theory suggests that students who have received feedback that their academic ability is relatively low would invest less in education because it would not raise earnings as much as for those with greater ability.

The other major factor that influences the amount of education pursued is the availability of financing. Many students take loans to pursue further years of education, while others receive grants, scholarships, or financial assistance from their family. If a person receives money to help pay for education through scholarships, grants, and no/low-interest loans, then the cost of education decreases and the rate of return increases. Reducing the cost of education in this manner encourages higher amounts of educational investments.

Social observers are concerned that these two factors are positively correlated. Students who have stronger backgrounds and higher ability may also be more likely to come from families with more resources. Weaker students may come from families that have fewer resources. Because stronger students would pursue more education in the absence of free financing and weaker students less, a positive correlation of ability and financing reinforces those patterns.

In terms of influencing wage determination, those with more formal education generally receive higher wages because they possess more skills. Employers look at courses of education as one factor that determines whether a worker carries useful skills. Because workers who are more skilled receive higher pay, many countries emphasize improvements in their national education systems as a method of raising average rates of pay and material well-being.

Wage Determination and On-the-Job Training

In some cases, firms may have an incentive to invest in general skills of workers through on-the-job training. However, most employers use this method to teach skills that are useful only in their own firm. If firms did invest in general education for workers, the employees would receive a wage rate low enough to pay fully for the training. Here, the discussion focuses on training in specific skills. The seminal work of Becker (1962) and Mincer (1974) also explains the role of on-the-job training.

Specific training increases workers’ productivity with their current employer after it is completed. From the perspective of the firm, if the worker quits after receiving training, then the firm absorbs the lost cost of instruction. From the employees’ perspective, if they take reduced pay during the training period, and the firm fires them, then the workers have made a human capital investment that is worthless to other potential employers. Because both parties have something to lose, they need a positive incentive to participate in on-the-job training.

The firm and the worker share the risks of on-the-job training by splitting the costs and the benefits from it. With specific training, workers earn lower wages than they might receive elsewhere during the training period. However, as long as the wages are reduced by a fraction of the training costs, the worker shares only part of the cost of investment. So the firm and worker bear part of the cost. After training is completed, workers’ pay remains below the actual value of the increased output associated with their new skills, but they will receive a wage that is larger than what they would earn at a different employer both at that moment and over their career. Thus, both the worker and firm have a positive incentive to participate in specific training.

General and Specific Training and Displaced Workers

To examine empirically how general and specific human capital affects wage determination, economists examine the experiences of displaced workers. Job displacement refers to the loss of employment due to plant closure or large-scale layoff. While it is possible that employers use layoffs to purge problematic workers from a firm, when layoffs are of a massive scale or when an entire firm closes, economists view this type of event as beyond the control of the worker. Because of this, researchers treat events like plant closure as naturally occurring social experiments. The workers who lose jobs change firms. Thus, the component of wages related to specific firms is lost. By comparing displaced workers’ wages to those of individuals who remain continuously employed, researchers can get an idea of the proportion of wages related to specific ties to individual firms.

Empirically, when workers experience job displacement, earnings drop significantly. In summaries of the literature, Lori Kletzer (1998) and Bruce Fallick (1996) report that earnings are below where they would be if displacement had not occurred for several years afterward; however, earnings usually recover to within 10% to 15% of their prior level in a 5-year period. The magnitude of displaced workers’ long-term earnings losses provides an estimate of the proportion of wages related to firm-specific factors.

Because the U.S. education system emphasizes the acquisition of general skills, one might be interested in knowing whether this small proportion of skills arising from attachment to specific employers is unique to the United States or if other countries exhibit this pattern. There is reasonable evidence from France (Abowd, Kramarz, & Margolis, 1999) and Germany (Couch, 2001) that the proportion of pay attributable to specific employers is in the range of 10% to 20% as is the case for the United States (Couch & Placzek, in press).

Why Are Age-Earnings Profiles Positively Sloped?

The method of discovery in any science, including economics, involves formulating theories meant to be useful in explaining empirical observations. Researchers gauge the validity of competing theories by examining whether they are consistent with empirical reality.

Human capital theory (Becker, 1962; Mincer, 1974) originally sought to explain why wages grow at younger ages, peak at midlife, and decline afterward. The extension of human capital theory to life cycle considerations by Yoram Ben-Porath (1967) predicts that early in life people should specialize in acquiring general skills because forgone earnings are smaller costs of acquiring education at younger ages. As individuals enter the labor market and obtain general skills from work and specific skills from employers, wages will grow over time. Eventually, as workers’ energy declines and reinvestments in skills taper off, wages fall. Finally, the worker exits the labor market.

The previous section described the proportionate contribution of general and specific skills to wage growth. However, economists debate about how strong the linkage is between wage growth and worker productivity at any given point in time. There are two major alternative theories of why wages grow over time: efficiency wages and job matching. Efforts to test the theories simultaneously in order to determine which effect is dominant are ongoing in the profession.

Efficiency Wages

In many workplaces, employers face difficulty in knowing whether their employees are putting forth the appropriate level of effort. When employees use paid time for nonwork activities, they are shirking their responsibilities. One way employers respond to this behavior is by using wages to encourage greater effort, or efficiency, from workers (Krueger & Summers, 1988).

Early in an individual’s career, a firm might choose to pay wages that are smaller than the actual value of the person’s product. This can be an effective device for learning which employees are most committed to the firm. However, if workers do not expect full payment for their efforts, they will move to a higher-paying employer because the total stream of compensation would be larger. To offset this concern, the firm must overpay the workers later in their career. Additionally, these theories require the firm to have the ability either to terminate older workers so that total compensation over their lives does not exceed the value of their output, or to use other mechanisms such as the structure of pension payments to induce retirement of workers at a desired point. The essential distinction between this and human capital theories is that over the majority of the individual’s life cycle, wage rates are not tied to the dollar value of worker productivity at a point in time.

One common example of a labor market with efficiency wages is academics. Younger faculty are often more productive than their older counterparts. Whether a new faculty member will receive tenure (a guarantee of employment) is normally determined 6 years after beginning employment. A university may be concerned that once a professor receives tenure that person will reduce his or her level of productivity. For the first 6 years, the university underpays and overworks junior faculty. The university heavily scrutinizes their productivity records. This screening is arguably sufficient to assure that the person being evaluated is devoted enough to research and teaching that he or she will remain productive after receiving tenure. Often, when a professor receives tenure, pay increases. When older professors are not as active in producing research, they receive wages that are large relative to their productivity.

The above example describes how efficiency wages work to increase productivity over time. Firms also use efficiency wages in a static context to increase worker productivity. In that case, efficiency wages are payments by firms structured to provide incentives to workers to be more productive or efficient in their efforts. Examples of efficiency wages include payments aimed at maintaining a healthy workforce, attracting more productive workers, and keeping employees from shirking their responsibilities.

Job Matching

Job matching theory provides an alternative view of wage growth. According to this theory, workers seeking employment receive job offers. As workers and firms match, they both need to discover whether the match is good. This discovery process takes time. During this process, workers are willing to accept lower wages in the hopes that the match is good. If firms and workers decide that the match is good, then wages increase and the pay is higher because the firm finds that the worker is valuable. Because the worker is happy there, the employment relationship is more durable. Thus, this theory predicts that wages grow over time primarily because of a good initial match with a firm. Empirical evidence from Robert Topel (1991) supports this theory because it finds that neither the length of time a person has spent in the labor market nor the length of time a person has worked for a particular employer is systematically reflected in wages.

Discrimination and Wage Determination

Generally, there are three actors in the market: workers, firms, and customers. Becker (1971) explained how in a complete economy discriminatory behavior by any one of these actors affects wages. He defined discrimination as what occurs when someone in a market is willing to pay a price for prejudice against a person or group. Prejudice in a labor market entails treating someone differently because of nonmarket factors unrelated to productivity, such as gender or race.

If employers discriminate against a group, then they will act as if the wage they must pay for a worker has an extra price embedded in it. This means that if a firm hires someone it dislikes, then that worker must accept lower pay.

Similarly, if customers are prejudiced, then they will pay a higher price for a product rather than do business with someone they dislike. Some businesses counter customer prejudice by hiring minorities for jobs that are not visible to the public. For minority-owned firms to gain business of prejudiced customers, they must accept reduced payment for their services.

Workers themselves can also be prejudiced. There are jobs that some think of as appropriate only for a certain type of worker. For example, many think of caregiving jobs as being most appropriate for women. Social pressure exists for women to accept caregiving roles not only in life but also in their choice of work (Friedan & Quindlan, 1964). When this type of pattern arises, workers can be crowded into specific occupations. This oversupply of labor depresses wages in those markets.

Measuring Discrimination

Ronald Oaxaca (1973) developed a method to measure the impact of discrimination in labor markets. This method estimates how much of a pay gap between minority workers and a comparison group (usually prime-aged white males) arises because of observed factors. After accounting for observed differences in productivity, the remainder, or residual, is interpreted to be an upper bound on discrimination’s effect on wages.

Beginning in the 1970s, wage inequality increased in the United States for all groups of workers. According to research by Gottschalk and Moffitt (1994), approximately half of the increase in inequality is unexplained. Using Oaxaca’s method, this increasing inequality would be included in the residual or unexplained category. To correct this, Chinhui Juhn, Kevin Murphy, and Brooks Pierce (1993) extended Oaxaca’s method so that general increases in wage inequality common to all workers would not be attributed to discrimination.

The Black-White Pay Gap

Kenneth Couch and Mary Daly (2004) show that for both recent entrants to the labor market and prime-aged workers, the overall black-white pay gap in the United States has declined to historic lows. For prime-aged workers, the overall pay gap remains at about 25%, with about half of it unexplained. This unexplained component provides an upper bound on discrimination’s impact on pay. For those with less than 10 years of experience, the pay gap is around 15%, with about 80% of the gap unexplained. For both prime-aged and younger male workers, discrimination appears to reduce wage rates of blacks by approximately 12 percentage points.

The Male-Female Pay Gap

In recent estimates of gender discrimination’s impact on wages, Louis Christofides, Qi Li, Zhenjuan Liu, and Insik Min (2003) report that among participants in the labor market, women’s pay remains at about a 26% deficit relative to men. Nine percentage points of that gap are explained by observable differences between women and men.

Policy Implications

The government takes two broad philosophical approaches to intervening in markets. The first approach entails identifying a market failure and trying to correct it through regulation or taxation. The second approach arises when there is no specific market failure but the competitive outcome is socially unacceptable and needs alteration even if there are costs, in terms of economic efficiency, of doing so.

It is not always easy to determine which perspective is behind government action because most intervention in economic affairs requires agreement of many people holding different views. Nonetheless, it is clear that the government is active in managing rates of pay, market structures, educational attainment, and discrimination in the labor market.

Rates of Pay

Since the passage of the Fair Labor Standards Act in 1938, the U.S. Congress has set minimum rates of pay for workers in specific industries and occupations. Proponents of minimum wage statutes argue that some jobs are beneath the dignity of American workers (see the discussion in Burkhauser, Couch, & Glenn, 1996). According to this view, even if raising wages reduces demand for workers and unemployment rises, losing those jobs is appropriate because Americans should not work for such low pay. Others (Card & Krueger, 1997) have argued that imposing minimum wage standards is inconsequential because this legislation has no adverse affects on employment. However, this is a point of contention in the profession (Burkhauser, Couch, & Wittenberg, 2000).

Some argue that there are more effective ways than legislating minimum wages to get money into the hands of the working poor. This is because many who work for the minimum wage are teenagers or secondary earners in the household. For example, for every dollar of cost, direct tax rebates put approximately $0.85 into the hands of a low-income household versus $0.15 out of every dollar of a minimum wage increase (Burkhauser, Couch, & Glenn, 1996). Regardless of whether one agrees that minimum wages reduce employment or truly assist the working poor, it is undeniable that federal and state governments intervene directly in the labor market.

Market Structure

The primary motivation for regulating industrial structure is to prevent the deleterious effects that arise from having too few firms in a market. The U.S. government assesses whether mergers of large corporations would create an anticompetitive environment within an industry. The authority to assess the appropriateness of firm mergers is established through statutes, including the Sherman Antitrust Act, the Clayton Act, and the Federal Trade Commission Act.

Most researchers who study the impacts of antitrust regulation focus on the impacts on consumer prices or the negative effects for U.S. firms in international markets if the firms’ sizes are insufficient to compete effectively. As discussed previously, another positive impact of retaining a large number of smaller firms in an industry is a more competitive market for workers. Economic theory suggests markets with more firms will tend to pay higher wages.

Educational Policy

Because of its role in developing worker skills, the formal educational system in every country is linked to the labor market. At the secondary level, some courses impart general skills useful to anyone as they move toward becoming a functioning adult in society. Other courses impart general skills while tracking students into college. Students who are not interested in postsecondary education and have specific job interests receive training through vocational courses designed for specific occupations (automotive technician, electrician) while still in high school.

Across countries, the amount of emphasis placed on each of these components varies. Each country makes decisions regarding the educational system’s structure, intending to promote wage growth. For example, in the United States, roughly twice as many students as in Germany attend postsecondary education. Few students at the secondary level in the United States participate in education aimed at a specific occupation, while formal occupational apprenticeships are normal in Germany among high school students not tracked toward college (Couch, 1994). The advantage the United States hopes to gain by having more workers trained with higher levels of general skills is greater worker flexibility. Germany hopes to have workers who are more productive because they are more specifically trained for their occupation. Germany hopes that the higher productivity arising from more skills that are specific will justify higher wages and result in more vital, competitive firms. A consensus has not evolved as to which system is better.

Countries also vary in their approaches to reducing the influence of family wealth on educational attainment. One’s birth family is a matter of luck, and denying an able student access to education because of lack of financing is economically inefficient because a valuable resource is underused. Most would say that to limit a person’s outcomes based on his or her birth family is also unfair. In the United States, the system of universities consists of both private and public institutions, most of which charge tuition. To increase access, government loans and grants are available to students, and the terms and amount of financing are related to family background. In many other countries, the university system is public. Once a student graduates from high school and qualifies for admission to a university, the government pays tuition and other expenses. Whether the education system is public or private, the availability of courses and the extent of public subsidy reflect considerations of economic efficiency, fairness, and long-term economic welfare.


When someone is treated differently because of color or gender rather than productivity, it is understandable that inefficiency results. If the most able person to complete a job is from a minority group and prejudice relegates that person to some other occupation, then a loss of productivity results. Moreover, differential treatment based on race or gender is patently unjust.

For reasons of justice as well as economic efficiency, the government plays an active role in ensuring that persons of equal capability receive equal treatment. In the United States, most of the laws that prevent discrimination arose in the 1960s. The Equal Pay Act of 1963 established that men and women working in jobs that require “equal skill, effort, and responsibility” receive equal pay. The Civil Rights Act of 1964 made it illegal to discriminate in employment practices based on “race, color, religion, sex or national origin.” Executive Order 11246, signed by President Lyndon Johnson in 1965, prohibited employment discrimination by contractors performing work for the federal government. It also resulted in the establishment of the Office of Federal Contract Compliance, which oversees the affirmative action plans of employers doing business with the federal government.

After these measures were enacted, racial pay inequality declined rapidly in the United States (Couch & Daly, 2004); however, concurrently, racial differences in employment widened (Fairlie & Sundstrom, 1999). It is hard to understand why the proportion of minorities employed would fall and proportion of minorities unemployed would rise in a period when relative pay rose. Recently, this same pattern has arisen again. Racial pay inequality declined in the 1990s, yet observable factors cannot explain the racial difference in unemployment (Couch & Daly, 2004; Couch & Fairlie, 2008). Two principal explanations have emerged for this phenomenon. Some think that discrimination that used to be operational in steering minorities to lower-paid occupations in a firm and denying promotional advances may have moved into the hiring decision (Couch & Fairlie, 2010). Others argue that expansion of government assistance programs has raised unemployment among less-skilled workers (Murray, 1986).

Gender pay differences have been more static over time. Some think that this is due to the passage of laws aimed at reducing racial discrimination at the time when women from the baby boom generation were entering the labor force. There is some evidence that to meet hiring goals for minorities, employers substituted African Americans for women. Additionally, even though average family sizes have declined, women are more likely to have interruptions in their labor market experiences relative to men, and this would reduce their value to employers. These factors help explain, in part, why the observed male-female pay gap for people with comparable education and experience remains persistent.

Future Directions

While research has lead economists to understand a great deal about the processes by which wage rates are set and the broad set of influences on wage rates, much remains to be learned. For example, economists have yet to determine which theory of wage growth best describes the operation of the labor market. The reason that understanding this is important is that if much of wage growth is determined by being matched into a good job rather than from investing in the expensive process of skill formation, then from a policy perspective, greater effort should be devoted to getting workers into the right firm.

Similarly, while a great deal has been learned about the role of prejudice in the labor market, a clear explanation has not emerged as to why relative pay rates of minorities and whites have converged but rates of unemployment have diverged. Some research points to factors that are likely to be part of the explanation, but no convincing, comprehensive explanation has emerged.


The rate of pay for workers is one of the basic determinants of individual well-being. The combination of wages and hours worked ultimately determines workers’ earnings. Admittedly, most individuals do live in a familial context that also affects their economic circumstances. Nonetheless, the wage rate individuals can earn, along with the time they have available for work, places a fundamental constraint on their consumption possibilities.

Average wages place a similar constraint on societal well-being. Government action can influence many of the factors that affect wage rates. The government has determined that some wage rates are too low to be socially acceptable and has set limits. Similarly, an industry with too few firms deviates in important ways from a competitive market structure, and the government reviews corporate mergers likely to affect adversely the relevant industry. The skills that individuals would like to develop to raise their own productivity are seen as vital to economic progress, and every country manipulates its educational policy to try to assist skill development among its citizens. Having all citizens participate in the economy on an equal basis also promotes economic efficiency, and governments routinely take measures to make opportunities uniform for all citizens.


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