Who Really Determines Wages?

Many people have the impression that business owners unilaterally determine wages and prices. They believe that consumers have little control in the process of setting either prices or wages. People who believe this are gravely mistaken about how the price discovery process actually works. Prices are ultimately determined by what consumers willingly pay. In any market free of intervention, consumers have the ultimate control over the determination of all prices and wages.

I will attempt to describe this very complex process with the use of three diagrams that depict three different scenarios. More than likely I will need to revisit this topic because it can be rather difficult to explain.

The Initial Conditions

I will use the following chart to help demonstrate the first scenario and to set the stage for the scenarios that following:

Initial Conditions
The Initial Conditions

This chart depicts an analysis used to determine the breakeven point for this particular business.

The sloping line that ascends upward to the right, beginning at $1,000, indicates the total expenses for producing the number of units shown on the bottom axis.

The total expenses consist of fixed expenses that do not change regardless of the number of units produced — in this case $1000 – plus variable expenses.

Variable expenses consist of those expenses that increase, incrementally, with the number of units produced. On this chart the distance from the fixed expenses to the total expense line represents the amount of variable expenses.

The upward sloping line that begins at zero, marked by the small squares, represents the amount of total revenues.

The difference between total revenues and total expenses, at a particular volume of sales, equals the amount of profit or loss realized by the business.

This chart does not have a time dimension. It represents the number of units produced and sold over a fixed period of time. Although most businesses don’t break their expenses down to such a small timeframe, I have chosen, for this example, to use the timeframe of one hour. I’ve done this so I compare hourly wage rates.

I have assumed that each worker can produce four units per hour. Thus, it takes 25 workers to produce 100 units, 75 workers to produce 300 units, and 125 workers to produce 500 units. The amount of pay does not influence the production rate.

The owner of this business has discovered, as a result of trial and error over several years, that, at a price of $5 per unit, he can consistently sell 600 units per hour. This volume of sales will generate total revenues of $3000 per hour. To produce 600 units, he must hire 150 workers. To make a small profit of $200 per hour he can afford to pay his workers $2,800 in total, which amounts to $12 per hour per worker.

The Effect of Increased Wages

This business owner has been under considerable social pressure to raise the wages of his workers to $15 an hour. He wants to pay his workers a reasonable wage, but he’s not sure whether he can afford a $15 an hour wage rate.

But, see what happens if he raises those wages without making any changes in his prices:

First Effect of Higher Wages
First Effect of Higher Wages

Because the owner continues to sell his product at the same price the demand remains the same at 600 units per hour. The additional expense of the higher wages for his workers, however, adds enough to his total expenses that, instead of achieving a profit, this little company now loses $250 per hour.

The owner realizes almost immediately that he has no alternative. He must raise his prices. If he continues to absorb losses at this rate, he will go out of business and there will be no jobs at any wage.

He decides to raise his unit price from five dollars to six dollars.

What effect does this have?

Adjusting for Increased Wages & Prices

After he raises his price, a couple of significant things occur as depicted in the chart below:

Higher Wages & Prices
Adjusting for Higher Wages & Higher Prices

The price increase would increase his total revenue at every level of sales. If he could maintain the 600-unit per hour sales volume, he could pay his workers the higher wage and still maintain healthy profit.

The consumers, on the other hand, don’t agree.

The 20 percent increase in the unit price makes some of them decide that they cannot afford to buy the product. As a result the sales volume of the business falls to 500 units per hour. Because the workers each still only produce four units per hour, the owner realizes that he must cut back his production staff to 125 workers.

The higher wage has forced 25 people out of work.

As much as the business owner would’ve liked to continue employing the same number of workers at $15 an hour, many consumers just won’t bear the additional cost.

Thus, the consumers really decide whether a company can raise its wages.

Advocates of higher mandated wage minimums should consider the effect on employment. “Minimum wage” laws prohibit business from offering jobs at lower wages to people who would willingly accept those wages. These people seem to prefer some unemployment at mandated wages levels than full employment at voluntary wage levels.

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