Determinants of Wage Levels and Individual Wages

Determinants of Wage Levels and Individual Wages


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This article describes the idea of a pay level for the organization and its parts. It shows the importance of the pay level and what determines the level.

The pay level is the average salary paid to employees. This may mean all employees, some particular group of employees or a single employee of the organization. This has two implications. The first is external: how does the organization compare with other organizations? This question is a strategic one of how the organization wishes to position itself in the marketplace. The second implication is internal. The average wage is a reflection of the total wage bill of the organization. Labor is one of the claimants on organizational resources. The size of the wage bill is a reflection of monies paid to entry level workers to the top executive.

The decision on compensation levels (how much will the organization pay?) may be the most important pay decision the organization makes: a potential employee’s acceptance usually turns on this decision, and a large segment of the employer’s costs are determined by it.

Organizations have a wide range of discretion in setting pay levels. Although organizations seek out and use information on what other employers pay, this information is only one of the determinants of pay levels. This chapter attempts to set out some of these salary determinants and the manner in which they may be used. Although no claim is made that all wage-level determinants have been identified, it is hoped that enough are presented here to illustrate the process used and the factors considered when an organization decides how much to pay.

Determinants of Wage Levels and Individual Wages


Numerous forces operate as salary determinants. These might be roughly classified as economic, institutional, behavioral, and equity considerations. Pay decisions appear to be made by comparison to labor markets, so many of the determinants appear to be economic. Both the meaning and force of economic variables are interpreted by organization decision makers, and these determinants are tempered by institutional, behavioral, and ethical variables.

There is no doubt that salary determinants operate through labor markets and that they include economic forces. More profitable organizations tend to pay higher salaries for the same occupations than less profitable organizations. Capital-intensive organizations tend to be more profitable because additional capital usually increases productivity. Small organizations tend to pay lower salaries often because those wages are all they can afford. Service industries that tend to be labor-intensive, low-profit, and low-pay are often composed of small organizations.

Local labor markets vary in pay levels, depending on industrial composition. Communities in which a large proportion of organizations are in high-profit industries tend to be high paying communities and often have a higher cost of living. Communities with a high proportion of organizations in low-profit industries tend to have lower pay. Sometimes communities experience short-run increases in pay levels because labor demand increases compared to labor supply; or there is a decrease in pay levels because of an increase in labor supply without a proportional increase in demand.

Differentials among local labor markets are limited by a tendency for workers to leave low pay communities and for organizations to locate new plants in low pay areas. Unions sometimes attempt to eliminate differentials by making a concession in work rules affecting productivity.

Pay levels tend to increase faster in good times: profits increase and this encourages workers to become more demanding and mobile. Unions reinforce this tendency by insisting on using gains made elsewhere to make their comparisons. Some less efficient organizations survive by paying less and lowering standards of employability even in good times. High profits, good times and increasing productivity tend to increase an organization’s ability to increase pay levels, but organizations may or may not be willing to pay higher salaries. Some of them do so to simplify recruiting problems and to forestall turnover. Others do so because above-average profits whet the appetites of workers and their unions. Most organizations tend to adopt a position in the wage structure of the community and attempt to maintain that position.

Thus economic forces operate on pay decisions through the actions of decision makers. If decision makers believe that adjustments in salaries are necessary or desirable on economic or other grounds, they make them. If they believe that the organization’s present pay level is prudent and acceptable, they do not.

In the remainder of this chapter we classify pay level determinants on the basis of (1) employer ability to pay, (2) employer willingness to pay, and (3) employee (or potential employee) acceptance. Although some of these considerations have been used by arbitrators and compensation boards, little is known about how they are used by organizations or unions. We therefore emphasize how and when these determinants could be used by organizations.


When asked most organizations would say that the major determinant of their pay level is the market rate. However, there is usually a caveat to this and that is their statement “if we can afford it.” So it would seem that the pay level of the organization is determined by external forces of the market but that the reality of the organizations financial position may modify or overrule carrying out this desire. This is expressed in surveys that ask about what determines the organization’s pay level.2 When these organizations say “if they can afford it” they are invoking the ability to pay. However, there is little that explains exactly what the ability to pay is.

As reported, more profitable firms tend to pay higher salaries, whether their profitability is based on the product market, technical efficiency, management ability, size, or some other factor. The situation with the automobile industry is an example of what can happen when an industry that is highly profitable falls on bad times and its pay level must fall in order to survive. This has been particularly hard since the industry is highly unionized.

In a very real sense, salary determination by the organization is an assessment of its ability to pay. The weight attached to other salary determinants may be determined by this estimate. Salaries are labor costs to employers, and these costs are high or low depending on what the employer gets in return in the way of effort and results.

What the employer actually pays is labor cost per unit of output; this is the labor costs divided by these results — termed productivity. A prospective salary increase may or may not increase labor cost per unit, depending on anticipated changes in productivity. A salary increase that would be offset by increases in productivity does not increase labor costs and meets the requirement of ability to pay. A salary increase that increases labor costs, however, requires determining whether the increase can be passed on to customers or offset by a reduction in other costs. Success in either effort again meets the requirements of ability to pay.

Similarly, a union presumably attempts to estimate an organization’s ability to pay before making its demands. High current profits or favorable future prospects signal ability to pay and strengthen the union’s bargaining power. Unions have a very long history and some early union contracts tied wages to ability to pay. For example, a 1919 printing agreement tied pay to economic conditions in the industry. Contracts covering motion picture operators have based pay on the seating capacity of theaters. Coal industry agreements have tied pay to the productivity of coal fields. Sliding-scale agreements have aligned pay to selling prices.4 Both the United Steelworkers and the United Auto Workers attempted (unsuccessfully) to secure agreements tying prospective pay increases in their industries to company profits.5 It is not likely today that this would be seen by the workers as a good bargain.

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Although employers profess to use ability to pay (or inability to pay) as a salary determinant, little is known about how they measure it. An early study found a number of organizations that estimated ability to pay by inserting a projected pay increase into the latest income statement. This definition accords closely with the definition contained in a glossary of compensation terms published by World at Work that states: “The ability of a firm to pay a given level of wages or to fund a wage increase while remaining profitable.”

Actually, ability to pay is a composite of the economic forces facing a firm. As such, it involves decisions on how profits should be measured, against what standard (net worth or sales), and over what period. It also involves determining an appropriate rate of return and resolving the issues, such as product development, product mix, and pricing policy, that most affect profits.

Organizations probably react to the ability to pay when they perceive their ability is in danger. Executives are more likely to bring up the ability to pay in pay discussions than are compensation experts. Further, lowering pay and other methods of reducing costs are more likely to be perceived as fair in bad economic times.

The way in which organizations use salary surveys suggests that they do so in a variety of ways. Organizations often say they use salary surveys to evaluate their ability to pay. If by evaluate they mean determine, this would be somewhat surprising, because surveys would logically reflect willingness to pay. This suggests that willingness to pay is a more important determinant for organizations.

Actually, ability to pay is a composite of the economic forces facing a firm. As such, it involves decisions on how profits should be measured, against what standard (net worth or sales), and over what period. It also involves determining an appropriate rate of return and resolving the issues, such as product development, product mix, and pricing policy, that most affect profits.

Although employers and unions may cite ability to pay or inability to pay as a primary reason for pay decisions, no one suggests that it be used as the sole determinant. Such a strict application of ability to pay could lead to very undesirable results. It would, for example, completely disorganize pay relationships. Pay levels would bear no relationship to the market rate in the labor market. Organizations in the same industry could have vastly different pay levels. Salaries would fluctuate widely along with profits. Any semblance of industry pay uniformity (usually strongly desired by unions) would disappear. Low-profit firms employing a high proportion of highly skilled people could have lower pay levels than high-profit firms employing only unskilled labor. In this way, unskilled labor could receive higher pay than highly skilled labor.

Strong limits, moreover, would be placed on economic efficiency. Under a system wherein increases in profits are absorbed by salaries, an efficient management would have nothing to gain from increased effort and inefficient management would be subsidized by low pay. In addition, employees could not leave inefficient organizations for more efficient ones, because expansion of output and employment in efficient firms would be forestalled by the paying out of increased profits in salaries to current employees. Incentives for management to improve efficiency would be seriously impaired. Possibilities of expansion would be limited.

For these reasons strict application of ability to pay is likely to hold little attraction for the parties. On the other hand, the general economic environment of the economy, the industry, and the firm is important in salary determination. When the demand for the product or service of an organization is strong, when potential employees are relatively scarce, and when prices can be increased without reduction in sales, unions are likely to point to ability to pay, placing management in a poor position to plead inability to pay. When economic conditions facing the industry, or especially the organization, are unfavorable, management estimates of inability to pay may set a low limit to salary increases.

Union reactions to situations in which a company faces financial hardship are pragmatic: although they are strongly opposed to subsidizing inefficient organizations. While organizations report using ability to pay as a salary determinant in collective bargaining, such use is subject to strongly held opinions. Most union leaders consider ability to pay as irrelevant unless high profits are apparent. Most employers consider it no business of the union. The force of ability to pay is probably best seen at the extremes, in judging whether a pay adjustment, apparently justifiable on other grounds, can or cannot be met. Strong evidence of favorable prospects causes employers to have less resistance to prospective increases in pay levels. Similarly, strong evidence of unfavorable prospects reduces pressure for a pay increase, especially if it is feared that such a pay adjustment might cause loss of jobs, and greatly increases employer resistance.

Ability to pay is an expression of the economic forces that bear on wage determination. Although it is a determinant beset by measurement and forecasting problems, search theory suggests that organizations are able to estimate it when a decision calls for it.


Productivity was used earlier in this section as a shorthand term for what the employer gets in return for the cost of labor. Thus pay level determination is often referred to as the effort bargain.

Actually, as will be seen, productivity is a result of the application of human and other resources. As such, it is a prime determinant of ability to pay. If production increases in the same proportion as pay, labor cost per unit remains unchanged. If, however, an increase in the pay level is not matched with a proportional increase in productivity, labor costs per unit rise. At some point this mismatch runs the risk of exceeding the employer’s ability to pay. Although productivity is not widely used as an explicit pay level determinant, it is always present in the form of the effort bargain. If the employer gets more output for each unit of input, the organization’s ability to pay is increased. For this reason, productivity deserves some discussion as part of the concept of ability to pay.

What is productivity? How is it measured? Productivity refers to a comparison between the quantity of goods or services produced and the quantity of resources employed in turning out these goods or services. It is the ratio of output to input. But output can be compared with various kinds of inputs: hours worked, the total of labor and capital inputs, or something in between. The results of these different comparisons are different, as are their meanings; different comparisons are appropriate to different questions. Two main concepts and measurements of productivity are used, but for different purposes. The first, output per hours worked or labor productivity, answers questions concerning the effectiveness of human labor under the varying circumstances of labor quality, amount of equipment, sale of output, methods of production, and so on. The second, output per unit of capital and labor (total factor productivity), measures the efficiency of labor and capital combined. This second measure gauges whether efficiency in the conversion of labor and capital into output is rising or falling as a result of changes in technology, size, character of the economic organization, management skills, and many other determinants. It is more complex and more limited in use.

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The first measure, output per hours worked, is the appropriate measure to employ in pay questions. It reflects the combined effect of changes (1) in the efficiency with which labor and capital are used, (2) in the amount of tangible capital employed with each hour of labor, and (3) the average quality of labor. It is these three factors that have been found to best explain the long-term trend in the general level of real wages.

It should be emphasized that labor productivity measures the contributions not just of labor alone, but of all the input factors. In fact, the potential for estimating the contribution of various factors makes measures of labor productivity at various levels appropriate, or inappropriate, for use as wage standards.9

Output per hours worked. Output per hours worked can be measured at the job, plant, industry, or economy level.

At the job level, it is possible to measure worker application and effort separately from other inputs as the basis for incentive plans.

At the plant level, estimates of the source of productivity increases can be used as the basis of gainsharing plans. At the industry level, productivity improvements cannot be traced separately to the behavior of workers, managers, or investors in the industry. The contributions of one industry to another industry’s productivity cannot be separated. Therefore the use of industry productivity as a salary determinant would have adverse economic consequences. For these reasons, industry productivity is seldom suggested as a salary determinant.

Historically, at the level of the economy, changes in labor productivity have been used as appropriate for salary determination. In fact, the improvement factor in labor contracts employed in the automobile industry from 1948 until the early 1980s is an example of such a use. Then in the 1960s wage-price guideposts were based on the argument that pay increases in organizations should be determined by economy-wide advances in productivity. However, this formula use of productivity for salary determination has advocates and opponents. Advocates point out that increasing pay levels in specific organizations, in accordance with annual increases in productivity in the economy, insures that productivity gains get distributed. They also argue that distributing these gains through price reductions may contribute to economic instability.

Opponents point out that although there is a long-term relationship between productivity and pay, the short-term relationship is highly variable, which suggests that other salary-determining forces are more pertinent. They also argue that tying pay to productivity yields stable prices only when productivity increases are accepted as a limit to salary increases. Obviously, when the cost of living is increasing, limiting salary increases to productivity increases would be unpalatable to employees. Even more unacceptable would be pay cuts when economy-wide productivity declines, as has sometimes occurred.

In auto contracts, the improvement factor was accompanied by a cost-of-living escalator clause and other pay increases. The guideposts broke down when price increases made the limiting of pay increases to economy-wide productivity increases impractical. The effect, of course, was to build higher prices into the cost structure that over time led to the demise of manufacturing automobiles in the U.S.

The inflationary potential of productivity formulas that are not accepted as limits is enhanced by a tendency to seek a productivity measure that makes larger pay increases feasible. Increases in industry productivity, for example, may be higher, but industry indexes are less reliable and more variable. Such indexes may also conceal the contribution of one industry to anothers productivity. Even indexes of national productivity may overstate non-inflationary pay increase possibilities, by failing to measure the effects of transfers of workers from lower- to higher-productivity industries and other sources of increase in labor quality.

Perhaps enough problems have been cited to argue against pay increases in strict accordance with productivity increases. The difficulty of securing acceptance of pay increases, based on national productivity as a limit, argues against the use of such a formula. Different industries and organizations have such varying rates of change in productivity that it would be inappropriate to make pay decisions based solely on productivity without taking into consideration other factors. Higher-productivity industries would be penalized for their higher productivity, and this would harm the economy.

Productivity, however, may be interpreted to mean that increases in labor productivity at constant pay levels will lower labor cost per unit. This operates through ability to pay. Productivity may also be employed in the narrower sense – that a productivity increase attributed to increased performance by employees calls for an equivalent increase in pay (as with merit increases or variable pay plans). Although productivity increases are often mentioned in salary determination, especially in labor negotiations, their effect as a separate consideration is probably minimal.

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The 1970s and 80s showed a decline in productivity growth in the U.S. In fact, some of that time period shows a decline in productivity. The 1990s showed a resurgence in productivity growth with very high levels from 1995 onward. This has been attributed to technological change and is credited to the robust economy of those years. This productivity growth rate continued into the early 2000s despite a downturn in the economy.10 Interest in productivity as a salary determinant seems to ebb and flow with these changes. A major variable is the cost of living which tends to run counter to productivity gains. This will be covered later in this chapter.


Employer willingness to pay may be a more powerful salary determinant than employer ability to pay. Organizations frequently obtain and use information on what other employers pay. Such information is undoubtedly the most used pay level consideration, sometimes considered along with the cost of living. Another determinant of employer willingness to pay consists of the state of supply of particular skills and the presence of tight or loose labor markets. This section devotes some attention to each of these salary determinants.

Comparable Wages

Comparable salaries constitute, without a doubt, the most widely used salary determinant. They represent the way in which organizations achieve the compensation goal of being competitive. Not only are the salaries of federal employees keyed directly to comparable salaries in labor markets, but also those of most public employees in other jurisdictions. Also, unions emphasize “coercive comparisons,” and private organizations consciously try to keep up with changes in market rates. Perhaps the major reason for this widespread use of the concept of comparable wages is its apparent fairness. In this view, comparable salaries help in the attraction and retention goals of compensation. To most people, an acceptable definition of fair pay are the salaries paid by other employers for the same type of work. Employers find this definition reasonable because it implies that their competitors are paying the same rate. In essence then, labor costs become “leveled” across the industry. Another reason for the popularity of the concept is its apparent simplicity. At first glance, it appears quite simple to “pay the market rate.”

However, determining an appropriate market rate is not so simple. Precise techniques, carefully employed, are required to find comparable jobs and comparable salary rates. Numerous decisions must be made: which organizations and which jobs should be compared and what is the best way to compare them? Equally important are decisions concerning how to analyze the data and use the results. Salary comparisons may involve other organizations in the area or in the industry, wherever located. These decisions will be examined in more detail in the next chapter on salary surveys. An important question to consider is whether differences in competitive conditions in the product market are significant enough to warrant a different pay level, regardless of labor-market influences.

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The market rate is an abstraction, the result of numerous decisions on what jobs and organizations to include, what wage information is appropriate, and what statistical methods to employ. Some employers decide to pay on the high side of the market, others on the low side as indicated in the previous chapter. The result is a range of rates to which various statistical measures may be applied. Various interpretations of the market rate may be made and justified.

To rely on comparable salaries as a salary determinant is to rely on salaries as income rather than as costs. Comparable salary rates may represent entirely different levels of labor costs in two different organizations. Setting pay levels strictly on the basis of market rates could impose severe hardships on one organization but a much lower labor cost on another. These difficulties are not insurmountable: many employers lean heavily on salary surveys. Employer choices on what surveys to use, what benchmark jobs to select, and how to analyze, interpret, and use the data suggest that reasonable accommodations to “the market” are usually possible. The next chapter on salary surveys will go into depth on this.

In addition to offering a certain measurability, following comparable salaries contains a good deal of economic wisdom. Salaries are prices. One function of price in a competitive economy is the allocation of resources. Use of comparable salary data operates roughly to allocate human resources among employers.

Furthermore, comparisons simplify the task of decision makers and negotiators. Once appropriate comparisons are decided upon, difficulties are minimized. A pay level can be set where the salary becomes satisfactory as income and operates reasonably well in its allocation function. Salaries as costs are also satisfied because unit labor costs can differ widely between two organizations having identical pay rates; also unit labor costs can be identical in two organizations having widely different pay rates.

Comparable wages also operate as a force for generalizing changes in pay levels, regardless of the source of change. Unfortunately, however, although changes in market rates tell what occurred, they don’t tell why it occurred. The changes may represent institutional, behavioral, or ethical considerations more than economic ones.

On balance, however, comparable salaries probably operate as a conservative force. Because pay decisions involve future costs, employers are understandably unwilling to outdistance competitors. In a tight labor market, changes in market rates may compel an organization to pay more to get and keep a labor force, especially of critical skills. But in more normal periods, where unemployment exceeds job vacancies, employers will more likely focus on equalizing their labor costs with those of product-market competitors. In other words, comparable salaries are followed as long as other considerations are not more compelling.

Cost of Living

Cost of living is emphasized by workers and their unions as a pay level consideration when it is rising rapidly. In such times, they pressure employers to adjust salaries to offset the rise. In part, these demands represent a plea for increases to offset reductions in real wages (wages divided by the cost of living). Pay pressures resulting from changes in the cost of living fluctuate with the growth rate at which living costs rise. However, market rate increases in most years have produced employee expectations of at least the same annual pay increases. To employees a satisfactory pay plan must reflect the effect of inflation on financial needs. This can come into conflict with the current emphasis on variable pay.

Employers understandably resist increasing pay levels on the basis of increases in the cost of living unless changes in competitive market rates and/or productivity fully reflect these changes, which they seldom do. Increases in the cost of living are partially translated into pay increases by most employers through payment of comparable salaries, and long-term contracts with unions have fostered other methods of incorporating cost-of- living changes. One such method is the reopening clause, which permits wages to be renegotiated during a long-term contract. Another is the deferred wage increase: an attempt to anticipate economic changes at the time the contract is signed. A third is the escalator clause by which wages are adjusted during the contract period in accordance with changes in the cost of living. In this third method, cost of living changes are measured by changes in the Consumer Price Index.

Escalator clauses vary in popularity from year to year in accordance with changes in the cost-of-living growth rate during the period immediately preceding the signing of the contract and with anticipation of subsequent rises. In the past, as much as 60 percent of workers under large union contracts have been covered by escalator clauses. Periods of reduced inflation tend to reduce their popularity.

Nonunion employers are much less likely to adjust wage levels in accord with changes in the cost of living or at least to admit that they do. Most organizations would claim that they grant merit pay increases each year. However, when all or almost all employees get the same increase it looks more like a cost-of-living adjustment. In extreme conditions, such as the late 1970s double-digit inflation, organizations were prompted to make significant cost-of-living adjustments.

Employing the cost of living as a salary determinant is somewhat controversial. Pay rates do tend to follow changes in the cost of living in the short run. Tying pay to changes in the cost of living provides a measure of fairness to employees by ensuring that their real wages are not devalued. But using the cost of living as a determinant also implies a constant standard of living. Historically, unions have opposed the principle for this reason. Methods that provide the same absolute cost-of-living adjustment for all employees may actually impair fairness to employees. Such flat adjustments imply that everyone’s cost of living is the same and has changed by the same amount. Unfortunately, technical problems in measuring changes in the cost of living may make such effects inequitable.

Labor Market Rates and the Cost of Living. The argument can be made that there is no particular correlation between changes in labor market rates and the cost of living as the two are based upon very different measures. Labor market rates and their changes are based upon the supply and demand for labor which often changes without any consideration of the cost of living. Determinants of Wage Levels and Individual Wages, Determinants of Wage Levels and Individual Wages, Determinants of Wage Levels and Individual Wages, Determinants of Wage Levels and Individual Wages, Determinants of Wage Levels and Individual Wages, Determinants of Wage Levels and Individual Wages, Determinants of Wage Levels and Individual Wages, Determinants of Wage Levels and Individual Wages, Determinants of Wage Levels and Individual Wages, Determinants of Wage Levels and Individual Wages.

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