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## How workers and firms determine wages

Usually wages are determined by a process of bargaining between workers and firms. The level of wages will depend upon the respective bargaining power of each side, and so conditions in the labour market will come into play here. When unemployment is high, it’s a ‘buyers market’ for firms wanting to hire workers, they know they have a large pool of unemployed labour to choose from so they can offer lower wages. Workers will take the jobs because they are just happy to have jobs. On the other hand, when unemployment is low, firms have to try to compete with each other for workers, so this bids up wages. Workers who aren’t happy with their wage offer at a particular firm will just go and work for a rival, and low unemployment means they might be quite hard to replace.

Blanchard uses this equation as the wage-setting relation: $W=P^e F(u,z)$.

This basically means wages are equal to expected prices multiplied by a function of u (unemployment), and z (a ‘catch-all’ variable covering various other factors at play in the labour market).

Lets look at those in more detail:

Expected prices – workers and firms will have a general idea in their minds about the level of expected prices, in other words they will factor inflation into their wage bargaining. If for instance your wages last year were £20000, and you know inflation is 3%, then you know that an offer of £20600 this year will basically be worth the same in real terms. If inflation is 5% then an offer of £21000 this year will be worth the same in real terms. You need to know this before you start wage bargaining so that you can have an idea of your starting point. Of course the firm will know this as well, if the workers try arguing for a 5% pay rise ‘to keep pace with the cost of living’ and inflation is actually only 2%, the firm will tell them to forget it. This concept that expected prices form part of wage bargaining is crucial to the understanding of how inflation persists and how it is hard to get rid of it when it starts to accelerate.

Unemployment – basically as discussed above, high unemployment gives more bargaining power to firms, low unemployment gives more bargaining power to workers. So wages will depend negatively on the unemployment rate.

The catch-all variable, z – this will include things like the levels of unemployment benefit and welfare legislation (higher benefits increase the reservation wage, the minimum wage at which workers are willing to accept work), or the level of trade union power which will also influence workers’ bargaining power. Basically anything other than unemployment, which determines the relative bargaining power of workers and firms, comes into the catch-all.