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How Are Wages Determined in the U.S.?

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There is no one way that wages are determined in the United States. In general, wages are determined by supply and demand, but they can be influenced by a wide variety of factors, including the cost of living in a particular area, the presence of a union and the current minimum wage. Pay rates also vary by gender, race, education level and skill level of the workforce.

How Are Wages Determined?

Before we can discuss how wages are determined in labor markets, it’s important to recognize that there are multiple answers. Overall, U.S. wages are driven by the basic law of supply and demand. However, individual employers can set wages based on how much money a particular position will bring in. Added to that is the fact that candidates often negotiate a salary based on their own unique qualifications.

Another factor complicating any wage discussion is the presence of unions in some sectors. Although the power of unions in the U.S. has decreased in recent years, unions still exist in some areas, and that has an effect on wages. Also, the federal minimum wage can create something called market equilibrium, which helps stabilize pay.

The Supply and Demand Effect

In general, wages are determined by supply and demand, so if you’re in a city with more available jobs than workers, pay is likely to increase as employers in the area compete for the same small talent pool. Conversely, in an area with an overabundance of workers, pay will go down as fewer positions become available. Supply and demand also directly correlate with the type of work someone does. In recent years, the talent shortage has shifted to areas like home health care and hospitality as more people get college degrees in other areas. This means employers have to pay more to fill those positions, naturally driving salaries up.

The Monopsony Effect

Although in general, wages are determined by the laws of supply and demand, wages tend to be higher in areas where more than one company dominates. This is known as a monopsony, and in a given market can also have an impact on wages. In a monopsony, the buyer, or the job candidate in an employment situation, is able to name his price because many sellers are vying for him.

A monopsony is the opposite of a monopoly. In a monopoly, wages may be lower because there’s only one seller and many buyers. So, if you live in a small town where the only major employer is a manufacturing plant, wages will likely be lower because there’s a wider pool of candidates for each job opening due to a monopoly. If you’re in a large town with numerous employers and only a few people who specialize in what you do, it’s a monopsony, and pay will tend to be more competitive.

Impact of Experience on Wages

On an individual basis, there are other factors that can affect a person’s wages. The perception is that more experience will earn you a higher salary, but that isn’t always the case. In fact, a more senior worker could find herself being phased out of her job once she reaches a certain level, since a more novice worker will request a smaller salary. In other cases, employees find that someone with less experience is nevertheless hired at a higher pay rate, possibly by negotiating it during the hiring process.

The level of pay for more experience can vary from one field to another. In the health care field, studies have shown that full-time workers with 10 years or more of experience earn significantly more over time than their less-experienced coworkers. Supply and demand can also come into play here. In a sector or location where your skills are heavily needed, you may find yourself commanding higher pay, whereas in a field in which plenty of people are qualified, pay may not be as high.

Impact of Education on Wages

Although it can vary from one person to another, overall a higher level of education leads to greater wages for professionals. According to the Bureau of Labor Statistics, the unemployment rate is significantly lower among degreed professionals than those who have a high school education or less. Overall, salaries are higher among degreed professionals, as well.

However, as more people pursue a college education, a new problem has emerged. The demand for highly skilled trade workers is on the rise, with some earning higher salaries than their degreed peers. At the same time, as degreed professionals tend to oversaturate various markets, they find they’re having to compete with many others who have their same qualifications.

Cost of Living and Wages

Certain cities are known for having high costs of living. If you live in Manhattan, for example, you can expect to pay between $4,000 and $5,000 a month for an apartment, while you can rent a two-bedroom apartment in Gulfport, Mississippi, for about $778 a month. When the cost of living is higher in an area, employers must pay higher wages to compensate, which is why the typical salary for a position can vary dramatically from one market to another.

One way businesses are getting around that need is by hiring remote workers. An employer in high-priced Manhattan could find a professional with the same experience in Gulfport, Mississippi, who is willing to work for less. Even an employee willing to occasionally commute to the office while living in nearby New Jersey or Connecticut might be willing to take a lower salary than someone trying to make a $4,000 monthly rent payment in Manhattan.

Some workers have been able to find areas that have both low costs of living and high wages, a combination that can be very beneficial. In Oklahoma City, for instance, the average annual income is $72,385, while the median monthly rent is just over $1,000. Kansas City, Lexington, Phoenix, Durham and Omaha also have wide gaps between typical earnings and the cost of living.

How Unions Affect Wages

In situations where workers are protected by unions, wages can be higher due to something called collective bargaining. When someone is acting on behalf of a larger group, an employer is pressured to listen in order to avoid a situation like a strike. Studies have shown that workers represented by unions tend to earn more and have better benefits, on average, than similarly skilled workers who aren’t represented by unions.

Often when experts discuss how wages are determined in labor markets, there are debates as to whether unions hurt or help workers. Higher-skilled workers are more likely to be represented by a union, which can create a wage gap in some areas. If a company becomes unionized, a wage gap can also be created by employees who choose not to join the union, which could make some workers feel pressured to join in order to enjoy the same pay as coworkers.

Theory of Negotiated Wages

Economists use the theory of negotiated wages to explain the higher pay seen in areas with union-represented workers. The theory of negotiated wages states that this power comes from the collective bargaining strength of large numbers of people joining together.

Seniority also factors into the theory of negotiated wages when unions are involved. In workforces represented by unions, the employees who have been with an organization the longest generally have higher wages than those who are newer. This gives unions more collective bargaining power, possibly boosting wages for everyone involved.

Minimum Wage and Market Equilibrium

Any time economists discuss how wages are determined in labor markets, minimum wage enters the conversation. With minimum wage, the government mandates that no employer can pay less than a set hourly figure. As of publication, the federal minimum wage is $7.25, but 29 states and D.C. have their own minimum wages that exceed that amount.

The term, market equilibrium, refers to the point at which the wages being paid are equal to the going rate that employers want to pay and that workers are willing to accept. When the government ups the minimum wage, it upsets that equilibrium because the minimum rate employers have to pay exceeds what they’re currently paying. This often leads to a reduction in hiring, in effect creating at least a temporary increase in unemployment.

Wage Gaps by Demographics

Unfortunately, there continues to be a gap in pay in the U.S. between various genders and races. According to the Institute for Women’s Policy Research, the gap between genders widened from 2017 to 2018, with women earning 81.1 percent of what a man earns. This is a decrease of 0.7 percent.

That gap is only more noticeable when race is factored in. Women of all races and ethnicities earn less than men at the same level, although Asian women are closest to closing that gap. Hispanic women earn less than all other women workers. A wage gap has a direct impact on poverty levels, the Institute believes, in part because it inhibits the ability of single mothers to earn a wage sufficient to raise a family without help.

Impact of Immigration on Wages

There has been much discussion as to how heavily immigration impacts wages. To calculate this, economists use something called wage elasticity, which measures how much the presence of immigrants affects overall wage rates. Some reports name a wage elasticity of -0.2 when immigrants enter the picture, which means a 10 percent increase in the number of immigrants would drop wages by an average of 2 percent.

However, this impact has a direct relationship to the types of jobs immigrants occupy. Largely affected are low-skilled native workers, such as those who work in construction or manufacturing. Also affected, though, are the highly skilled technology workers whose positions may be filled by immigrants who participate in the H-1B visa programs.

In both these cases, though, without immigrants there would likely be a talent shortage. In fact, experts in the construction industry have pointed directly to a decrease in immigration as a reason for the current talent shortage they’re experiencing. Immigrants make up about 30 percent of the construction industry in most states. Finding domestic workers to fill these shortages is an ongoing challenge as officials continue to try to get young students interested in working in fields where shortages exist.

The Productivity Pay Gap

In the mid-1900s, workers' pay seemed to rise in direct correlation to how productive they were. When the economy was thriving, workers were paid more, justifying the harder work that was expected of them to keep things flowing. However, since 1973, the gap between how productive employees are and how much they’re paid has widened significantly.

The problem with the productivity pay gap is that much of the wealth exists at the top of the ladder, with decreasing amounts trickling down to lower-tier workers. This has led to something called wage stagnation, which becomes a problem for everyone. Leaders have difficulty retaining good talent, leading to a constant revolving door where they lose money on recruiting, interviewing and training. Wage stagnation also leads to low morale, which can affect overall productivity and even create a toxic work culture.

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About the Author

Stephanie Faris is a novelist and business writer whose work has appeared on numerous small business blogs, including Zappos, GoDaddy, 99Designs, and the Intuit Small Business Blog. She worked for the State of Tennessee for 19 years, the latter six of which were spent as a supervisor. She has written about business for entrepreneurs and marketing firms since 2011.