How are wages set? Why does geography affect the cost of labor more than the cost of goods?
The natural price of a good changes in accordance with changes in any of the costs of production. In The Wealth of Nations, Adam Smith identifies labor as one of these costs. He discusses how supply and demand, as well as the living conditions of workers, influence the cost of labor.
Continue reading to understand how the cost of labor operates in an economy.
The Cost of Labor
The price of any good includes the wages of the workers who produced it. Businesses must pay their workers, who are also pursuing their own self-interest and therefore wouldn’t work for free. Thus, the wages of workers involved in every step of the process are going to be included in the natural price. Smith identifies two factors that determine the cost of wages: labor markets and workers’ living conditions.
1) Labor Markets
To understand what raises or lowers the cost of labor, we need to look at labor markets. The principle of individual self-interest also governs labor markets, much like it governs markets for goods. Labor markets consist of a seller (the worker), trying to sell their labor for the highest price, and a buyer (the employer), trying to buy labor for the lowest price. The same principles of supply and demand apply: Anything that reduces the supply of workers in a given profession will drive up wages. For example, some professions require more training, education, or talent than others. These will have a smaller labor pool because there will be fewer people who can do the job. The same goes for jobs that most workers would rather avoid, such as morticians.
An increase in the demand for labor will also drive up wages. Smith asserts that rapid economic growth will raise wages because employers can afford to hire more workers. As demand for labor grows, employers will offer higher wages in an effort to compete with each other. However, a recession will lower wages. As fewer businesses can afford to hire workers, the demand will decrease, reducing the competition between employers.
(Shortform note: Many economists have argued for an approach to labor markets that takes into account psychological behaviors besides rational self-interest. For example, workers also take into account personal standards of “fairness” when deciding if a wage is desirable. They subjectively assess the future outlook of the economy when selecting a career choice. Workers may also minimize the risk of loss by staying in jobs for personal security, even when there’s a better option for them out there. Finally, organizing into unions also gives workers much more leverage to push for higher wages. However, it’s important to note that these behavioral dimensions don’t invalidate the principles of supply and demand but rather work in tandem with them to shape labor markets.)
2) Workers’ Living Conditions
Lastly, Smith explains that wages vary based on the workers’ living conditions. Wages must be enough so that workers can furnish themselves with food and housing.
Furthermore, there is greater regional variety in the rate of wages than there is for the cost of goods. Smith states that this is because it’s easier to transport goods long distances than it is to get people to move away from where they live: You can easily and cheaply transport most goods across long distances, so there isn’t likely to be much variety in the price of the same good from one region to the next.
Workers, however, are often unable or unwilling to move away from the area where they live or have close social connections. Therefore, workers tend to accept the prevailing local wage rather than constantly moving from town to town in search of better markets. This means that labor markets tend to operate across a smaller geographical radius than markets for goods, which makes it harder to bring different regional wages into a closer state of equality.
(Shortform note: The differences in wages between geographic areas only get wider when taken to an international scale. Workers in wealthier, developed countries can make much more doing very similar jobs to people in poorer, less-developed countries. Writing in Basic Economics, economist Thomas Sowell argues that this is because workers in developed countries are able to generate more value, and therefore their employers can afford to offer higher wages. They’re able to generate more value for their employers because they have more tools and materials at their disposal. For example, an accountant working with a computer could generate more value than one working with pencil and paper, even though they both have the same skills.)