The Process of Determining Minimum Wage

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This paper is based on the article “The wage policy of a firm” written by George Baker, Michael Gibbs, and Bengt Holmstrom. This article was published in the year 1994 (November) in the quarterly journal of economics, volume 109 from page 921-955. This article contains 22 references with 445 citations in later literature. According to google scholars, it is cited 816 times. The focus of this article is primarily based on Chapter 9th “Career Based incentives” of our syllabus. The paper addresses the three benchmark theories that have guided our analysis of the data which recalls the main findings from our companion paper [Baker, Gibbs, and Holmstrom 1994]. The demand for and the supply of labor play the key roles in determining wages in the competitive labor market. Wages are supposed to be determined by the bargaining power between employer and worker (union). We show aggregate wage patterns which consider individual wage patterns. The key learning studies show the relationship between wages, job levels, wage growth, and promotions. At last, we conclude result in our interpretation of the firm’s wage policy.

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According to the article, it is suggested that no book provide clear evidence that “what tool firm used to determine wage policy inside the firm”? Therefore, the research question in this article is based on field research and personal experience. The paper addresses the following research questions:

  1. What is the relative importance of individual performances versus job level in determining an employee’s wage?
  2. How responsive are wages to changes in the external labor market?
  3. How do real wages progress, and are they downward rigid?

Therefore, in this paper to clarify these questions we take data over the 20-year period from 1969-1988 of a single firm. This data represents about 20% of all labor force of firm managerial employee. Our main objective is to summarize the facts based on the research question in relevance to extant theories (Learning Model, On-the-Job Training Model, and Stationery Incentive theories) which helps to suggest firm actual wage policy of the firm.

Literature Review

Previous literature used: Previously, bargaining theories and game theoretic approach were used to determine wage policy by the firm. Bargaining Theories of behavioral approach: Walton and McKersie (1965) (WM afterward) develop a behavioral approach to the bargaining problem. They point out the bargaining process with 4 subprocesses.

  1. Distributive Bargaining
  2. Integrative Bargaining
  3. Attitudinal Structuring
  4. Interorganizational Bargaining

Walton and McKersie suggest that this subprocesses is used to determine the goals and tactics of union and employer while determining wages through this subprocess has its own different function and logic to sort out the problem between employer and union of the cohort. In this article, different scholars had done research related to wages and promotion, learning and incentives etc. The primary reference for on-the-job training is Becker [1975]. Farber and Gibbons [1991]. They provide an implication for learning model which is empirical and later proved an excellent treatment of the empirical implications. Holmstrom and Milgrom [1987] found stationery incentive model which is acknowledged as their research.

Literature related to theories: There are many theories discussed in this article such as learning theory, on-the-job training theory, and stationery incentive theory. But we found that after this marginal productivity of wage determination play a vital role in firm wage policy according to many works of literature. I. von Tunen and M. Longfield are the first people to work on the marginal productivity of theory. But later J. B. Clark has developed this theory. P. Samuelson, J. Hicks, E. Chamberlain, P. Douglas, and Joan Robinson, are some of the well-known representative of this theory. According to the marginal productivity of wage determination, the following assumption is based on to determine the wage policy of the firm.

  1. There is perfect competition in the product market and labor market.
  2. Labors are homogenous in the market.
  3. Profit maximization is a focus of the firm
  4. Resources are supposed to be fully employed.
  5. There is a law of variable proportion in the market.

Therefore, in the current modern world wage determination is based on an interaction between supply and demand curve in a market. The equilibrium point represents the wage rate for labor on the firm. This theory proposes that a more productive laborer receives higher pay. It is also known that wages are determined by the production optimization in terms of labor economics. Previous research of these theories has an impact till today because this theories data analyzed across year are similar. This paper has found descriptive model is used to determine wage policy in current years which is used by maximum single firms.

Finding: Our research objective is focused on four different finding which helps to determine wage policy inside the firm. They are:

  1. First, there must be clear evidence of a cohort effect which senses that there is evidence of an internal labor market. The cohort is measured on an observable difference of the same type of group at same time. This means the cohort who earn more at entry has a profitability to earn more on later time which means a marginal product is not determined solely by wages.
  2. The researchers suggest that individual wages are downward rigid. Therefore, it is experienced 15% real wages decline in the typical cohort of entrants of ten-year time and entrants are a manager with an age of 32 years old. It is found that 20% of employers do not get nominal wage increment in some years. Therefore, the research found that employee who does not get nominal wage increment two or three times as likely not to get increment nominal wages a further year.
  3. The research found that there are predictable winners and losers which shows there is a substantial serial correlation in real wage increases for individuals. Therefore, it is found that when employees observable characteristics are filtered out there is a sign of positive correlation in residual wage.
  4. Our 10-year period data imply that promotion is the central part of wage growth which shows a strong correlation between job level and wages. Moreover, it is concluded that wages grow primarily through promotions because wages are always compared with job levels also.

In the above figure, the solid line represents the average salary of the management employees in the sample firm and dashed line represents the current population survey of the industry data during the 20 years period. As we see the starting salary of the sample firm is high because they are all in managerial positions after that we can see the fluctuation in the firm average salary. During the half of the 1970s there is a dramatic drop and after from 1880, there is a slight upward trend. While the cps mean salary has just decreased by around 15% and then it rose by about 25% in the later years. So, from the above trends, we can easily imagine that inflation plays a major role in a real salary of employees. Next table below shows changes in average normal raises, average real raises, and inflation. The above table represents that there is a rise in percentage in average nominal and average real wages each year with inflation. if we regress nominal wages with inflation there is a positive correlation of 0. 2 so employees get a fair amount of inflation burden. Thus, we can say there is a positive relation between nominal wages and inflationFrom the above figure 2, a solid line represents the mean salary of new entrants and dashed line is the mean salary of cohorts. As we can see cohort wages is growing very slowly where a new entrant’s salary is just growing by 40 percent in the labor market during the period.

Furthermore, we can clearly see that the 1975 cohort salary is lower than the 1974 cohort and this gap is almost the same through the period. Similarly, 1980 cohort mean entry salary is less than of 1979 cohorts but is equal to 1981 cohorts. Thus, as a result, these variations come from the starting wages. so entry wages looks like more unusual and inconsistency patterns The smaller circle represents the year of promotion. The lowest line is the average salary for those still at their level after 10 years. We noted that wages tend to grow steadily up to the year of promotion, almost linearly. the wage patterns seem to serial correlation. For example, those promoted in the third year from level 2 to level 3 average a 4 percent increase in each of the years before promotions. Based on this evidence we can say that promotions are not the driving force of wage increases but it is just the significant predictors of promotionsThe key learning studies in this article show the relationship between wages, job levels, wage growth, and promotions. At last, we conclude result in our interpretation of the firm’s wage policy. From the analysis, it is proved that none of the theories of wage determination are clear at which level the firm determine wages.

Therefore, neo¬classical economists, especially J. B. Clark, in the late 1890s developed the marginal productivity of theory which helps to determine wages in the real-world market. The article address only three theories such as learning theory, on-the-job training theory and stationery incentive theory but these theories data used in these research paper are unable to explain data alone in labor market which means this article has only shown the field research to show what policy does firm used to analyze wage in labor market which is difficult to get enough evidence to know which wage policy is used in this global world.

Conclusion and future research direction: To sum up, evidence suggests that none of these 3 theories (learning theory, on the job training theory and Stationery incentive theory) alone can explain data while determining wages for the firm. These theories have their own drawbacks which are shown in the analysis part of this paper like learning theory cannot account for persistent external market conditions because it is based on hypothesis where wages are expected to marginal product whereas individual real wages decline due to difficulty in substantial run in analysis of data in on-the-job training model andin stationery incentive model wages growth are positively linked with promotions therefore it has a problem in clarifying data, why wages rise in percentage or dollar, is based on current salary?. These 3 theories together are used to describe data.

Therefore, in future research should be done on basis of a descriptive model also our data suggest that the descriptive model is used to analysis of data because employee differs in individual capabilities and individual rewards are based on current year performance not on past year performance. Furthermore, in comparison to typical incentive theories, key elements of the descriptive model are less sensitive to individual differences.

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