Determination of Salaries

How are salaries fixed? Are they controlled by companies? Or by the State? Perhaps they are controlled by syndicates? Or is it an obscure system controlled by hidden forces? Not at all. Long term, it?s a different story.

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The importance of productivity

Bilateral competition in the workforce is essential in order to reduce the influence of the powers that be. The fact that workers are able to choose among several companies allows them to avoid possible exploitation. In the same way, the fact that a company has the choice between several potential employees frees them from being beholden to too many demands. So in these conditions, provided that there is an absence of monopoly from the companies? side (for example in the form of a cartel) or the employees? side (for example in the form of labor unions), salaries are fixed at the level of marginal productivity of the employees. The company continues to hire as long as an employee yields more what he costs them. They will stop hiring when an additional employee costs them more that what he yields. Therefore, the marginal employee is paid to his maximum productivity.

Another argument leads to the same conclusion. It is true that each company wants to pay their employees the least amount possible for the work given. Imagine that all the companies suggest to their employees a salary which is lower than what he is worth. So, it would be in the company?s interest to suggest a salary slightly higher than the others in order to entice him while still enjoying the benefits (as his salary would stay inferior to his worth.) If we follow this reasoning, we realise that if many companies surrender to competition, each will have to pay an additional employer at the level of his productivity.

Work productivity is essentially determined by three factors:

- The capital per employee: the higher the capitalistic intensity is raised, the more productive is the worker. A such, favorisation of capital investment is therefore beneficial for the employees.

- Qualifications: appropriate training and pertinent experience increases productivity.

- Global productivity factors: the efficiency with which production factors are combined. Technologies of production (in the broad sense) and company organisation can increase the productivity of employees. Good management is thus favourable.

According to Adam Smith, at the origin of a nation?s wealth, labour division positively affects these three factors. It saves time, it allows for specialization of production factors which increases the need for training, it favours the development of mechanization (and thus of investment) and innovations, and it rationalises the productive process. Let us notice that business development - in particular international - together with a reduced cost of transport make it possible to improve productivity gains which is generated by a strengthening of labour division. That is why a trade liberalization benefits employees.

In the long-term, work productivity determines salaries. It is boosted by investment and good management from the company?s side, training and employees? experience as well as by business development

The environment of the company - namely transport and communication infrastructures, the presence of business partners and regulation - plays an equally essential role. Yet, the increasing tax and social security deductions explains the separation between the (strong) progression of work productivity and the (weak) progression of purchasing power. In particular, the progression of health expenses and retirement explains why productivity gains do not translate to corresponding purchasing power gains. According to INSEE, work productivity was multiplied by 2,3 between 1975 and 2004 and by 7,7 from 1950 to 2006. [1]

Source INSEE

Are certain careers too highly-payed? In other words, are there certain occupations where the remuneration does not correspond to the associated non-monetary costs? Certain careers are unpleasant, uninteresting, tiresome, stressful, dangerous, require costly training, demand long work hours, do not confer transferable skills or come with a strong probability of being dismissed: it is normal that workers are compensated for these costs. For example, careers in high finance are often stressful, require long working days and very specialized qualifications, and very often, many employees are dismissed: it is thus normal that the received salary compensates these inconveniences.

In principle, workforce operations move towards this balance: if an occupation is too highly remunerated, applications will pour in and salaries will lower; conversely, if a job is not remunerated enough (in comparison to other similar jobs), the workers will soon leave, so salaries will have to increase in order to keep these workers. This is the theory. Does it ring true in practice?

Remuneration can be separated from marginal productivity because of elements which seem to be brought about ex post by pure chance but can be justified ex ante for incentive reasons.
Patrick Bolton, Mathias Dewatripont

In observing the consequent differences among salaries in different sectors, Andrew Clark [2] also asked if annuities exist in the workforce. He defines an annuity as the part of a salary that exceeds the minimum amount necessary to ensure that a worker accepts a specific job. Of course, employees differ according to their skills (education, experience, etc.) and their personal characteristics (age, gender, etc.) By using a sample group and by following the individuals throughout the course of their career, he can take into account these established individual effects which allow the annuities to be identified by industry. Finally, he uses events such as closing of production units to ensure that employees?s movements are external. He found that annuities did not exist by sector but rather by occupation - certified accountants would be slightly “over” paid. In other words, salaries correspond more or less to the fair compensation of these careers. But not exactly. How can one explain this difference?

The causes of disparity

Workforce specialist Edward Lazear explains that salary distribution at one given moment does not have any significance. What matters is the salary scale, the salary profile over time. In effect, many jobs are poorly paid at the beginning of one?s career. Yet if the employee proves himself, he will be able to pursue betterpaid jobs. High salaries do not compensate for current effort, but for the effort shown previously in getting to his current position. The belief that salaries should be evenly distributed erroneously leads to the conclusion that certain jobs are excessively remunerated while others, insufficiently remunerated. Now, valid comparisons force us to consider all the "efforts" and salaries earned during a career. For example, company managers earn higher salaries due to their preliminary efforts. Patrick Bolton and Mathias Dewatripont even go so far as to say that "salaries can be separated from marginal productivity because of elements which seem ex post to be from pure luck, but can be justified ex ante for incentive reasons." [3]

This progressive system accounts only for an (artificial) part of this inequality. Then, this system must be conditional. For example, salary progress automatically linked to seniority without one being able to be dismissed has no moral incentive.

The salary scale of state employees is difficult to explain without evoking some argument. Economists would say that they act as an “anomaly” or a “puzzle”. That said, we can formulate a hypothesis based on the observation of two incontestable facts. Firstly, the average salary in government sectors is 30% superior to those in private sectors (see note on public expenses) even though the risks associated with the jobs in public sectors are less. Secondly, the pressure that state employees exert on their employer (the State) is incommensurable with those of most private employees. That is why the salary scale in the public service is probably the result of many political confrontations further to which certain state employees acquire guaranteed incomes - that is, an elevated salary for the years they have left, and a generous pension.

Salary distribution at one given moment does not have any significance. What matters is the salary scale, the salary profile over time.
Edward Lazear

Finally, without a competitive environment and with trade barriers, salary negotiations can benefit employees of a certain industry at the expense of consumers. Employees of the American automobile industry, with powerful trade unions, have for a number of years earned guaranteed incomes with their salary and the other benefits being maintained at superficially high levels [4]. The arrival of the foreign competition allowed a decrease in car prices and American automobile giants were not able to adapt. The industrial city of Detroit is now stricken and General Motors is accumulating the losses which amount to billions of dollars...

Insurance and Incentives

Most salaries are more or less fixed. Regardless of company benefits, employees earn the same amount. Generally, their salaries so not diminish when the benefits are few, but nor do they increase when the benefits grow. Why not associate salaries to the economic cycle? In other words, why not reduce their fixed salary and increase their variable salary? Simply because they are opposed to risk and because their salary is typically their major source of income. In these conditions, it is preferable that shareholders deal with these fluctuations, which will allow companies to insure their employees against salary variations.

Yet, certain salaries are variable and depend upon the performance of either the employee or the company. In effect, certain jobs can not be closely controlled. For example, a salesman who is often on the road and does not work in a company is under no one?s supervision. With a constant salary, nothing prevents him from spending his time strolling in the forests or sipping a beer in the corner bistro. In this case, one way to ensure that the employee makes the right decisions and makes a sufficient effort is to make his salary dependent upon his performance. For example, such a salesman will typically work on commission, and so will make a greater effort, thereby reaping the rewards. [5]

The same applies for company managers: they are constantly tempted by bad projects that they take to heart, naturally they suffer personal ambition or attachment towards certain parts of the organisation, they have a tendency to take too many risks or not enough risks, etc. In order for their interests to coincide with those of the company owners, their salary is often determined by the profits that they produce or by the course of the company?s shares in the stock exchange. Recently, stock-options were in fashion, more for accounting and fiscal reasons, rather than economical reasons, as explained by Hall and Murphy. [6] In particular, the induced convex payment profile is not necessarily optimal. A miracle solution does not exist, but as long as the State grants favours to certain means of remuneration and not others, the compensation of leaders will remain less than effective.

As for the level of payment for company managers, economists Augustin Landier and Xavier Gabaix have recently explained its increase since the 1980?s. [7] Even if a leader only slightly increases a company?s worth, it will have little impact due to the importance that the company places on high returns. This explains why companies are ready to pay more for the services of a good leader. The price of talent has simply increased!

EE , Pierre Chaigneau , July 2011

Article also available in : English EN | français FR


[1] Étude INSEE et Tableau INSEE

[2] ENS Paris-Jourdan, and Ecole d’Economie de Paris.

[3] Contract Theory, 2005, p.318.

[4] Article of Mark J. Perry

[5] Several studies have been released on the these incentives. For instance, read Harvesting the fruits of your labourers, Financial Times, Link to the article.

[6] Hall et Murphy, 2003, The trouble with stock-options.

[7] Gabaix et Landier, 2008 Why has CEO pay increased so much.

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