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Economics

The real Iron Law of Wages

One of the oldest fallacies in economics is that the amount of work done should be reflected in the amount of pecuniary reward received for doing it. How can it be fair that someone who slaves away for hours slicing kebab meat in a kitchen on a sweltering day earns £6.19 per hour while someone who kicks a football around for a few hours a week gets £2,040 per hour?

In fact, the amount of work we do is not commensurate with how much we are paid. Nor should it be. In the late 18th century for every bit of effort the average Indian textile worker put in he or she was paid just one sixth of what a British textile worker was paid for the same amount of effort because the British worker, with their greater capital stock, produced six times as much with that given amount of effort. Whatever our gut reactions, what wages reflect is not the ‘effort’ of the worker but their output and the market’s and the employers subjective valuation of that output.

When deciding whether or not to hire, and at what wage, an employer will only employ that person if  they think doing so will add more to turnover than to costs and they will not pay that person more than he or she is expected to add to turnover. To pay more would mean that that the employer is paying to employ that worker. This is the real Iron Law of Wages.

If a landlady has to pay £100 per week to hire a barman she will hire him if she expects doing so to add more than £100 per week in revenue. If hiring that first barman adds £150 per week to turnover, and a second barman (because of diminishing returns to labour) adds £140 both will be hired. If hiring a sixth barman adds £100 in revenue and hiring a seventh barman adds £90, then the landlady will hire six barmen at £100 per week.

If, however, a minimum wage is introduced which raises the cost of hiring a worker to £115 per week the fifth and sixth barman are now being paid more than they generate in revenue, their marginal product, so they will be laid off. The first four barmen are £15 a week better off, five and six are looking at their P45s.

The lesson is that raising minimum wages, as the Conservatives are now rumoured to be considering, makes some people better off but they also make some people worse off.

Some will deny this and say that the mass job losses predicted when the minimum wage was introduced never materialised. But what about the jobs never created? Number seven in our example who was never employed lost a job just as surely as did barmen five and six when the minimum wage was raised. Indeed, many advocates of higher minimum wages implicitly admit this by not pushing for a much higher minimum. Doing so, they admit, would lead to unemployment. But they can never explain why, if the demand curve for labour is downward sloping at one point, it is not so at another.

The only way to raise wages is to raise the marginal productivity of labour. To make labour more productive we either need to train it better (sending one of our barmen on a cocktail course so he can entice a lager drinker to splash out on a Pina Colada) or give it more capital to work with as in the textile example (optics on spirits bottles as opposed to measuring cups).

Sadly there is reluctance in Britain to pursue either of these paths. Our education system has been slipping compared to those in other nations and our financial system, with its addiction to low interest rates and focus on consumption, is inimical to capital accumulation. If the government is worried about low pay it needs to get serious about these issues. They are fundamental questions and attempts to mollify their symptoms with minimum wages are a waste of time.    

16 comments to The real Iron Law of Wages

  • Paul Marks Paul Marks

    A good article.

    As for the present government….

    Clearly they do not understand “macro” economics – in that they believe in wild government spending (the opposition are even worse, according to them the government should be spending even MORE money) and wild monetary policies also.

    If they go for this minimum wage (“let us increase incomes by passing a government edict”) stunt – it will prove they do not understand “micro” economics either.

  • Andy V

    It really shows what a basket case Conservatism has become in the UK under Cameron. Margaret Thatcher was an avid fan of Milton Friedman, perhaps Steve Baker can circulate a copy of Capitalism and Freedom around to his colleagues. It really just adds to the insanity of the sub prime mortgage lending scheme. Conservatives once used to realise that you interfere in the market at the peril of unintended consequences. I expect such proposals from the emotionals on the left, who will always make the argument ‘oh its not fair….’

  • Andrew Lees

    until government can inspire votes rather than buy them, they will continue to undermine the economy.

  • chuck martel

    Minimum wage legislation is even more of a moral issue than an economic one. Should government approval be required to validate a voluntary contract between two individuals?

    However, while Mr. Phelan’s article may be correct in theory, in the real world there are many deviations from that theory. Relatives of ownership and management, for instance, don’t occupy the same spot on the labor curve as strangers. Public employees and other bureaucrats, whose productivity is either impossible to measure or in actuality negative, receive compensation that’s unrelated to that fact.

    Corporate managers, who are, in fact, employees, receive astronomical salaries and bonuses based not on their decision-making, really the only thing they do, which is based on the information that they’re given by much lesser-paid underlings. They don’t discover cures for rabies or invent new forms of energy, they decide on marketing strategies and product design. But they are members of a rotating club, the elite managers, and one success, perhaps entirely based on good fortune, can mean a lifetime of luxury, regardless of their subsequent mediocrity or failure.

    • Andy V

      There are far easier ways, why not just have no tax, say up to 13k of earnings and then on a sliding scale. You simply cannot expect to pay a man for his skills which are worth less than market will pay for his work.

      Public employees and other bureaucrats who exist as a result of EU regulation or at the local level (since most of their funding comes through government) will always be a problem in the UK, until tax is represented at the local level, in both cases they are de facto- tax without representation.

      You definitely strike me as an emotional central planning leftie with your final comment. That you are more noble and wise to determine the salaries of people- that arise from people buying and selling goods from their own free will.

    • George Thompson

      It’s somewhat refreshing to note that there are visitors to this website with a knowledge of economics inferior to mine.

      The amount of money people are worth is based on a simple concept – whatever someone else is willing to pay them. Just like eggs, a person’s skills are commodities which can be bought and sold in the market. Potential hamburger flippers are plentiful and low-skilled. They are paid a fair rate for their services with respect to the market. The elite manager also has valuable skills – and the ability to make profitable decisions certainly qualifies. But not only must his employer pay an amount high enough to acquire those talents, the employer must outbid his competitors for those same services. There is nothing immoral about either a wee bit o’ luck now and then or is a company’s being able to earn a fair profit sufficient to allow all its employees to prosper to the best of their own unique skill sets. For if it is unprofitable, and violates the laws of the marketplace as you think proper, it soon goes bust and all its workers are sloughed off on the dole.

      I recommend you pick up a book about how free-markets work and why they are preferable to all others. I recommend any collection of essays by Dr. Walter E Williams. Each essay is short for those with Sesame Street attention spans and illustrates an important principle of sound economics. In particular he details how minimum wages were instituted at the behest of unions, at least in the USA, in order to suppress minority participation in the labor market and continues to this day to be the major impediment to unskilled inner-city drop-outs acquiring the essential job skills needed to improve their lot in life.

      What can be more moral than providing someone the skills needed to live free and prosper?

      • George Thompson

        I just wish to clarify that my reply is to Mr. Martel and not to Andy V who’s last paragraph is certainly spot on.

      • chuck martel

        “I recommend you pick up a book about how free-markets work and why they are preferable to all others.”
        ———————–
        What particular example of a free market did you have in mind? Is the limited number of available openings in the Harvard MBA program evidence of a free market? Are occupational licensing requirements for doctors, attorneys, pharmacists, barbers and even manicurists indicative of a free market? When the board of trustees of a large public university hire a new president they’re not paying him with their own money, they can pay him literally whatever he wants. (http://www.cleveland.com/metro/index.ssf/2013/07/former_ohio_state_university_p.html)

  • Another reason the introduction of minimum wages did not result in mass unemployment amongst the less skilled is that the min wage was around the minimum that anyone was prepared to work for anyway, given that there is not a bad living to be made living on benefits, especially if you get a little job paying cash on the side.

    John Phelan’s point about the marginal productivity of labour is correct. At least it’s obviously true to say that if the productivity of the marginal employee is improved via more training, then aggregate unemployment will decline (or to be more accurate NAIRU will decline). However that point could be invalidated by the possibility that we spend enough on training, and a better option is the reduce the marginal cost of labour to the employer.

    Unfortunately that point is beyond the comprehension of 99% of economists worldwide.

    The Work Programme actually reduces the marginal cost of labour but not in a desperately efficient way. I could re-design WP so that it targeted the marginal worker more accurately.

    Unfortunately, and to repeat, 99% of economists won’t have the faintest idea what I’m talking about here.

    • George Thompson

      Mr. Musgrave, you must admit, however, that those faint ideas are why that 99% is well-compensated by central planners at taxpayer expense.

  • Paul Marks Paul Marks

    The high level of corporate manager wages (and perks) is directly connected to the decline of the proportion of companies owned by individuals and families. Both government tax laws and government regulations favour institutional investors (such as pension funds) over individual share holders.

    Institutional shareholders are really hired managers (in the institutions) being in charge of other hired managers (at the corporation they have shares in) with no real OWNERS in the mix.

    In Germany (where individual and family share ownership controls far more companies than they do in Britain and the United States) the pay and perks of managers tend to be lower – because real owners (people interested in the long term success of the enterprise – not just the end of year results) are more important.

    In the end companies that are run for the benefit of the managers (not the long term interests of the shareowners) still fail in Britain and the United States – but the process of controlling hired managers tend to be less difficult where individual and family shareowners are more important (as they tend to be in Germany).

    See that dreadful man Warren Buffett – sniffing round German enterprises when there was a move to increase the taxation of inheritance.

    People like Buffett love inheritance tax – because it destroys family owned enterprises, enabling people such as himself to say “would it not be better to sell out to my corporation – you could put the money in a TRUST for your children……”

    Trust fund kids (not owner managers) and hired managers in charge (paying themselves telephone number pay and perks). That is the vision of the establishment (of the Economist magazine, the Financial Times newspaper and so on) and it is not a good vision for the long term – especially in manufacturing (banking and the financial industry tend to be government welfare zone anyway – pay and perks in these areas tends to be absurd because of the credit-money expansion of the Central Banks, the Federal Reserve, the Bank of England and so on).

  • Paul Marks Paul Marks

    Yes Mr Thompson – I am a Walter Williams fan.

    He is a reminder of the old conservative black community that used to exist in such cities as Philadelphia (before the 1960s movements, and even pre 1960s developments, destroyed them).

    As he says “I am thankful that I got my education before it became the fashion to like black people – that way people know my qualifications are real” (unlike Barack and Michelle Obama of course – neither of whom had the educational record to be even admitted into the universities they attended, they were admitted and supported on RACIAL grounds).

    As Dr Williams points out (in such books as “The State Against Blacks”) such “compassionate” policies as the Minimum Wage law and endless welfare, undermined the decent people in the black community – and boosted the power of the “activists”, the far-left race-hate types who have helped turn most American blacks into government supported clients for the Democrat party.

    “Seek ye first the political Kingdom, then all other things will be given unto you” (the words of the first President of independent Ghana) are as perverted (as false) in economics, as they are in theology.

    In the end there can be no compromise (not combining) of the noble vision of self help and mutual aid seen in such people a Booker T. Washington (or Walter Williams) and the vile “collective salvation” (political Heaven-on-Earth) vision of such Harvard people as WEB Du Bois and Barack Obama.

  • Paul Marks Paul Marks

    Chuck Martell.

    No one here would defend occupational licensing regulations, or the government subsidies to (vile) Harvard (or the rest of the “liberal” elite).

    On these things at least – we are all united.

  • Walter Williams for President! – they picked the wrong guy twice.

  • ..and Thomas Sowell as his VP..

  • ..he can have the casting vote when things have become incredibly fair and prosperous for all that it’s impossible to pick who can step back and do the most good:-)