Monday, April 18, 2011

Labor Econ 3: Wages and Marginal Product of Labor

(This is my article today in,

With the continued rise in the prices of oil, fare, electricity, food, other products and services, there is the usual clamor for a government-imposed wage hike across sectors. And the government announcement should preferably be done on Labor Day or two weeks from now.

This logic is faulty for two important reasons. One, employment in the private sector is a contract (wages, social security benefits, bonuses, leave with pay, etc.) between employers and employees, government is outside of this contract and thus, government imposition of wage hike is a distortion of this private contract. And two, wage is not a function of the changes in prices (increase or decrease) of oil, electricity, food and other goods and services; wage is a function of the productivity of labor in each firm, in each sector.

Consider this illustration and two graphs. A firm producing chairs, is deciding how many workers it should hire. Just 1, or 2, or 6 or more? There are fixed costs in the firm like office rental, average electricity bill, etc. The variable costs include number of workers (more workers, more costs, but hoping that it will also result in more sales and more profit).

The marginal product (or extra output) of each laborer is derived by deducting total output of say, 3 workers, with the output of 2 workers, and so on.

This illustration is suggesting that the firm should have only 3 or 4 employees, not 5 or 6 as the marginal product (MP) or extra output of the 5th and 6th workers are already low, if not zero. The MP curve (lower graph) is showing that a firm can make maximum profit with just 2 workers, but hiring a 3rd and possibly, 4th worker, can still increase the firm’s total product and hence, total revenues.

And that is how firms decide in how many workers to hire at what salary for each worker. The more skilled the worker, the higher is the wage plus other benefits.

If there is a pressure from the workers themselves, say through their labor union, to demand higher pay due to the rise in the prices of oil, electricity, food and other commodities, the employers and management may grant the wage hike demand, but that MP of each worker is also expected to rise. Thus, instead of producing an average of 8 chairs per day, workers will be expected to produce 9 or more chairs per day, through better tools and continuing training and skills improvement.

The more that people will think that the solution to economic problems is politics, the more politics and politician interventions they will get, and it will be counter-productive.

Wage and related benefits are mainly a function of, or determined by, labor productivity, not by the price of oil and other commodities nor by the number of children and dependents that a worker has.

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