The Theory and Practice of Pay Setting

Introduction

In modern economies employers purchase labor power from workers who, in general, obtain their income from the sale of their labor. For the employer, the wage is the price of labor: the cost of securing the worker's productive capacity. However, as management theorists (and efficiency wage theorists before them) tend to emphasize, pay can also be used to elicit greater worker effort. As Marx (1976) emphasized, employers generally purchase units of workers’ time rather than discrete units of effort. Employers can create incentives for workers to work more intensively over a given period - what Marx termed the ‘real subsumption of labour’- or to work more extensively, by increasing their working hours over a given day, or even over a career (through increased tenure). From the employee's perspective, pay is the reward for labor, that is, the actual effort of producing goods or services. The nature of the payment varies greatly across workers, and may include not only monetary income paid as labor is supplied, but also deferred payments, such as pensions, together with non-monetary rewards such as health insurance, which employees often rate as more valuable than their monetary equivalents (Dale-Olsen, 2006).

Despite these complexities, this characterization nonetheless implies that ‘pay’ is the outcome of a relatively straightforward, private, economic transaction in which workers receive pay in return for effort. But this is not the case for three reasons. First, social norms govern what is considered to be the appropriate trade-off between effort and reward. There is, for instance, a strong tradition of what constitutes a ‘fair day's work for a fair day's pay’. Moreover, governments may intervene when market-set wages do not meet the subsistence needs of workers, either requiring certain minimum pay levels or supplementing pay from public funds (for example, through tax credits).

A second reason is that employers are often judged by what they pay and employees by what they receive. Again, social norms play [Page 492]a role, since employers may gain plaudits for socially responsible behavior. But equally their stock price may respond positively to a lowering of labor costs. For employees, one's social status is often bound up with one's wage and even how it is paid (hourly, weekly or as an annual salary). It may bear directly upon well-being, not only in terms of what workers can wear and eat, but in terms of what they can borrow, and how they are perceived by colleagues, friends and relatives. Workers’ well-being is highly correlated with perceptions of their pay relative to their peers (Brown et al., 2005).

Third, employers and employees sometimes involve others in wage setting. Employees may join together to bargain with an employer, typically through a trade union. Similarly, employers may act collectively if they wish to avoid outbidding one another for scarce labor, thus ‘taking wages out of competition’ by setting single rates in particular industries, localities or occupations.

This chapter focuses on pay variance across workers, employers and across time and illustrates how theories of pay determination can shed light on this variance. We discuss the limitations of the orthodox economic approach to pay-setting and emphasize the importance of labor market imperfections, the role of institutions and the uniqueness of the labor contract in determining wage outcomes. Two broad conclusions emerge: first that no single theory has an overriding claim to virtue; and, second, that in spite of the knowledge generated within the field of industrial relations (IR), as will become apparent, much remains to be understood.

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