Price determination in labor market

According to the theory of labor economics, the labor market is where labor demand and supply interact. Moreover, the labor market reflects the economic relationships of these interactions. The market is a mechanism that allocates labor resources through two-way selection reflecting both demand and supply under the effect of the value law and the competition law. The labor market embodies an exchange relationship based on the employment of individuals. The labor market is composed of workers, employers, wages, and market organizers. Through labor, these agents influence the economy. Labor is a function that creates value reflecting the utility and capability of individuals. Labor has been an indispensable factor of economies since commodity production began. With the development of social production, labor has gradually become a more scarce resource, and the scarcity is reflected in the price of labor; that is, wages. The market pricing system for labor is based on labor exchange. Studies on labor demand and supply and the determination of fair pricing compose the main focus of labor market theories.

A review of labor market theories

As with normal commodity and factor markets, the labor market is a type of exchange relationship based on price. Wages represent the price of labor, and studies on wages have been conducted throughout the entire history of labor market development. In classical economic theory. Smith (1950) first addresses the division of labor in his analysis of the nature of wages and the influencing factors of wage differentials. The author analyzes demand and supply relations and wage changes, which form the basic theory framework for labor market research. Ricardo (1891) proposes the distribution theory of wage determination and argues that wages are determined by the cost of labor reproduction. Moreover, Ricardo analyzes wage change patterns. Say (1861) establishes the law of the labor market using the price theory of production cost as a foundation. He argues that the law of value is effective for goods, factor markets, and labor markets, and the law directs demand and supply toward equilibrium automatically. The law of value eliminates fluctuations in labor prices and ultimately attains full employment. Walras (1881) suggests marginal utility and marginal analysis based on classical economic theories. Jevons (1879) uses this method to analyze personal best choice behavior in labor markets and emphasizes that wage is determined by individual marginal productivity. Walras proposes the general equilibrium theory by investigating factors and including labor, capital, land, and goods markets. Marshall (1961) develops this theory further by adding the element of entrepreneurs’ management capability to three production factors and applies the equilibrium analysis to establish a full system of income distribution theory following neoclassical economics.

Neoclassical economics suggests that the price formation of labor is similar to that of ordinary commodities. Wages are determined by differences in workers’ abilities and by market demand and supply. The more capable the worker, the higher the labor efficiency, or the greater the extent to which labor supply exceeds demand and the higher the wage. However, the market is assumed to be perfectly competitive in neoclassical economics, which is in sharp contrast to the reality. Furthermore, labor market analyses are based on macro aggregates, which consider individual decision-making behavior to a lesser extent. In the real market, some heterogeneity exists in terms of the value of workers and their skills, but such differences in capability are obviously asymmetric with respect to wages. Equilibrium theory struggles to explain that workers receive different payment for the same job and unemployment coexists with high wages. Therefore, some scholars study labor markets from other perspectives.

Veblen (1934) and Commons (1936) are the first to study labor markets using institutional theory. The authors maintain that the labor market is imperfectly competitive and has institutional and social barriers in the flow of information and personnel, which emphasizes the role of trade unions, large enterprises, culture, customs, and other factors in wage determination. The authors also highlight the significance of economic power in the determination, which implies that wage theory is breaking through the category of things and adding human initiative. Stigler (1961) and McCall (1970) present the search theory of incomplete information. The authors argue that the information is incomplete in labor markets, and each individual in the market searches for information to find a better job and maximize their wage. Wages are proportional to information costs. Keynes (1937) uses macroeconomic aggregate analysis to study a non-full employment problem in labor markets, breaks through the theory that market mechanisms are effective unconditionally, and proposes the theoretical view that governments should intervene in the labor market. Since the onset of economic globalization and the emergence of the knowledge economy, labor market environmental factors have changed. New factors have been added to the wage formation mechanism that scholars have studied extensively, particularly in the fields of experimental economics and game theory. Some problems are discussed in depth, such as the wage formation process, the realization of equity and efficiency goals, and the effectiveness of resource allocation in the labor market.

As the price of labor, wage is similar in nature and function to any ordinary commodity. Wages are the recognition of labor’s value and the willingness to trade on both the demand and supply side. Wages reflect the macro-situation of demand and supply, such as the quantity demanded and supplied, the related changes in the market, and some micro-information on the basic attributes of labor as a commodity. For example, efficiency of labor, ability to create value, and labor substitutability. More importantly, wages are the primary mode of wealth distribution, which is the main income source for many workers. Moreover, wages are a channel for the distribution of corporate profits and wealth adjustment. The reasonableness of a wage is related to individuals’ expectations but also to the impact on social stability.

From the perspective of economic equity, a reasonable wage should be calculated based on the contribution that workers have invested in value creation through their efforts and realize under the competition principle of equal opportunity—the equal value exchange of the commodity of labor. Moreover, a reasonable wage should increase the incentive to work and labor efficiency by providing a fair trade. However, such a context of perfect competition does not exist in reality, and there is no auctioneer to ensure the fair distribution of interests in the market. The price mechanism of neoclassic economics does not take effect spontaneously. As a main form of interest distribution, salary formation is the result of negotiation between demand and supply. The macro price mechanism is actually the market reflection of the combined individual effect. Compared with the price formation mechanism of ordinary commodities, wage negotiation is more complicated. The result of negotiation depends on the resources owned by workers and on integrated economic power from all types of resources, which is embodied by the negotiation power of both the demand and supply side. Wages are simply the cooperative game solution attained through negotiations among firms and workers based on their resources.

According to Aoki’s explanation (1984), this game solution is characterized by the power balance among the players and the internal effectiveness of firms. The power mentioned by Aoki is the economic power of negotiating participants and the influence of each individual on others based on their resources to hand. On the labor supply side, sources of power include the physical and mental capabilities of workers and the information, knowledge, and the material wealth they possess. On the labor demand side, power resources include the wages offered and a series of non-monetary resources, such as the firm’s economic conditions, geographical location, management mode, development prospects, working environment, benefits, and interpersonal relationships.

Each of the resources could possibly provide realistic or long economic and non-economic benefits to the workers. The magnitude of power produced by these resources is related to their role in value creation, their scarcity, and the extent of their substitutability. The greater the role, the more scarce the resources and the more difficult to substitute; thus, the greater the power. That is, the greater the economic power of an entity, the more advantageous position it will assume in negotiations, and the more benefits it will obtain. Therefore, for the entire labor market, interest distribution is isomorphic to power; moreover, the power agent that affects interest distribution is not exogenous. Instead, the power agent is part of the market mechanism. Wages are the outcome of the strategy interactions among all players in the game.

Discussions on the distribution of firm benefits from the perspective of power have a long history in economic theory. Hobbes (1998) argues power is the current means to gain any obvious future benefits. Weber (2009) states power means that even if a person or persons are confronted with resistance from peers in their social activities, they will still have chances to realize the intended goals. Coase (2012) notes that frequent internal transactions in a firm are not controlled by price mechanisms but by power. However, power resources cover a wide range of sources, all of which have their respective attributes and lack references. Additionally, the effectiveness of exercising power, or the magnitude of negotiation power, is related to the quantity of resources possessed by the participants and the determination and will of the negotiators. When one party in the game is more willing to face public conflicts in the negotiation, the other party may be likely to make concessions (Aoki, Greif & Milgrom, 1984). Obviously, man’s will is invisible. It is hard to measure and define the magnitude of power derived from will, which makes a discussion on the issue of distributing firm’s interests and wage formation from the perspective of power difficult. Therefore, although, in theory, scholars have already recognized the importance of power, the analysis on the effect of power has been limited to only a description. In recent years, with the development of game theory, some scholars have attempted to explain how power affects both the employer and labor in games. The corresponding models have been established, which makes the analysis based on power an economic research paradigm. According to the main resources invested in value creation, we divide the labor market into three components—the ordinary labor market, the high-skilled labor market, and the executive labor market—and discuss the game process of wage formation from the perspective of power.

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