We all care about how our pay compares with similarly qualified colleagues. This
makes it very difficult for organisations to offer newly hired employees higher or
lower pay than existing employees. And according to new research by Professor
Jonathan P Thomas, published in the October 2005 issue of the Economic
Journal, it can explain why wages are considerably less variable and
employment considerably more variable than if labour markets behaved like
markets for other commodities following the laws of supply and demand.
The idea is straightforward. When a firm is hiring new workers, conventional
supply and demand analysis suggests that if the labour market is tight, say, with
low supply of workers or high demand, the price (wage) will have to rise to bring
supply and demand into balance. If, however, the possibility of internal
dissension means that the firm cannot pay newly hired workers at different rates
from existing workers, the analysis is very different.
In these circumstances, the firm cannot decide on its wage structures treating
new workers as an independent group: if it wants to pay a high rate to new
workers because the market is tight, then it will also have to pay existing workers
at this high rate. This could be very costly if the existing workers would have
been content to work at lower rates – and it means that the firm has an incentive
not to raise wages as far as it would do in the normal supply-demand analysis, so
wages do not respond fully to normal market signals.
The same thing happens when the labour market is slack in downturns: the firm
could potentially hire at lower wages but these new hires would not be content to
work alongside better paid but otherwise similar employees. The firm could cut
the pay of incumbents to match that of the new hires, but there are plenty of
reasons why this is difficult. The result is that the firm prefers to maintain the
existing wage structure and bring in new hires at this rate, even though it is
paying more than necessary to attract the new workers.
The paper puts these ideas into a formal theoretical model to show that when
firms cannot pay discriminate, wages are less variable and employment more
variable than would be the case in the absence of this restriction.
It also shows that unemployment may be involuntary in the sense that there may
be unemployed workers who would be willing to work at a wage below the going
wage. The point is that firms cannot offer a lower wage to an individual such
worker without cutting the wages of other workers if it is to avoid discriminating,
which it may not want to do.
While this is a theoretical paper, exploratory analysis of data on the pay of UK
graduates entering employment suggests that as a group, their pay is not more
variable than all employees. In other words, there is no evidence that the pay of
workers entering the labour market is more prone to the vagaries of the business
cycle than established workers. This is consistent with the hypothesis of the
paper that new workers cannot be discriminated against.
Professor Thomas notes that it is undisputable that pay relativities within
organisations matter. It is fair to say that economists do not have very good
theories to explain why an individual might be especially put out to find out that a
similarly qualified colleague is being paid at a higher rate. But we know that the
phenomenon exists though it seems that pay relativities between organisations
matter far less.
Understanding why this is so may well be more a matter of psychology than of
economic theory. Rather than trying to explain it, however, this paper takes this
observation as a starting point, and shows that it can help explain why wages
seem to vary much less than conventional models predict. Essentially, it can
explain why labour markets do not behave in a similar way to markets for other
commodities in which demand and supply are the determining forces.
ENDS
Notes for editors: ‘Fair Pay and a Wage-bill Argument for Low Real Wage
Cyclicality and Excessive Employment Variability’ by Jonathan P Thomas is
published in the October 2005 issue of the Economic Journal.
The author is at the University of Edinburgh.
For further information: contact Jonathan Thomas on 0131-650-4515 (mobile:
07876-797647; secretary: 0131-650-8363; email: Jonathan.Thomas@ed.ac.uk);
or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-
661095 (email: romesh@compuserve.com).