How Are Wages Determined? - Economic Commentary Findings on Employer Role in Wage-Setting - February 15, 1990

Sep 21, 2026

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Economic commentary examining how wages are determined, challenging the view of employers as mere price-takers in a classical competitive labor market. It argues that demographic and industry classifications explain only part of wage differences, while employer-specific wage differentials account for a large share. Using evidence from three labor markets in the Fourth Federal Reserve District, it links wage-setting insights to income distribution, poverty, consumer spending, and inflation dynamics.

LanguageEnglish

CategoryResearch & Report

FormatPDF

Pages5

Reading Time13 min

AccessFree to download

How Are Wages Determined?

Why Is It Important to Understand the Wage-Setting Process?

How Much Do Wages Vary by Employer?

by Erica L.Groshen Ror economists,wage determinationseems to be like the weather:a populartopic of conversation,but a subject thatinevitably remains open-ended.Part ofthe reason for this lack of resolution isthat economists tend to think of the labormarket as a classical competitive market.In that context,employers do not setwages;instead,they passively pay thewage that results from supply and de-mand conditions in the labor market. Seeing employers as price-takers,how-ever,does not explain many of the ob-served pattems of wages,such as wagevariation across industries for appar-ently equivalent workers.Nor does itexplain why employers perceive them-selves as choosing a wage within a mar-ket-determined range of feasible wages,and how they make that choice.Rather,evidence suggests that viewing employ-ers as wage-setters lends significant in-sight into the wage-setting process. Understanding wage determination isthe key to understanding important as-pects of the economy,such as incomedistribution,poverty,consumer spend-ing,and the perpetuation of inflation.Aline of inquiry that expands our under-standing of the wage-setting processpromises to provide insight into theseissues. This Economic Commentary presentssome findings on the employer's rolein wage-setting.These findings arebased on observed wage patternsamong individual employers inthreelabor markets in the Fourth Federal Re- # How Are Wages Determined? serve District:Cleveland,Cincinnati,and Pittsburgh. # ■ Why Is It Important toUnderstand the Wage-Setting Process? Ifemployers are price-takers,who sim-ply pay their employees a market-determined wage,then an individual'spay should depend almost entirely onhis or her characteristics(or human capi-tal):education,age,IQ,and experience.Even in the most detailed studies,how-ever,these factors explain less than halfof the wage variation in the population. Table 1 shows the limited explanatorypower of demographic information inthe Current Population Survey(CPS),by listing how much of the variation inwages is explained by four groupingsof variables.The results are typical ofthose found in household surveys. In this sample,the usual human capitalvariables(those included in group 1)explain only a quarter of the variationin the log of wages.Adding occupation(as in group 2)raises explanatorypower by 16 percent,while includingother demographic variables(those in-troduced in group 3—race,sex,andunion status)explains another 6 per-cent.Finally,in group 4,the introduc-tion of industry variables raises the ex-planatory power to 51 percent of thevariation of wages. What drives the half of wage variationthat all of these variables don't ex-plain?Would an understanding of these February 15,1990 Much of the variation in wagesamong employees cannot be ex-plained by the usual variables of indi-vidual worker characteristics,demographics,and industry classifica-tion.Based on evidence from threelabor markets in the Fourth FederalReserve District,the author finds thatemployer differentials account for alarge share of the variation in wages,with important implications for eco-nomics and management. unexplained wage pattems shed lighton the causes of movement in aggre-gate wages? For instance,the macroeconomic mod-els that help us understand and predictunemployment and inflation differ radi-cally in their assumptions about thewage-setting process.Classical Keynes-ian models assume rigid or“sticky”wages;companies do not adjust wagesdownward.In contrast,most real busi-ness cycle models assume immediateadjustment of wages,but slow adjust-ment of workers between jobs. Fifty years after Keynes,we still don'tknow in what way wages may besticky.For instance,are wage adjust-ments mostly employee-specific,or em-ployer-specific?When do wage adjust-ments precede inflation,and for whom,and when do they lag inflation?Do ag-gregate wage changes primarily reflectchanges in the composition of employ- ment or changes in wage rates to in-

FAQs

Why does the document say wage variation cannot be fully explained by standard worker characteristics?

Demographic information such as education, age, IQ, and experience explains less than half of wage variation, and even detailed household-survey variables leave much unexplained. The document attributes a large share of remaining variation to employer-specific differentials.

What evidence does the author use to study wage-setting by employers?

The analysis uses a longitudinal dataset tracking wages paid by a sample of employers across three cities in the Fourth Federal Reserve District, observing employers’ wage payments from 1955 through 1988 for specific occupations.

How does understanding wage-setting matter for macroeconomic outcomes?

The document links wage-setting to important economic aspects including income distribution, poverty, consumer spending, and the perpetuation or adjustment of inflation. It also discusses how different wage-setting assumptions affect models of unemployment and inflation.

Sep 21, 2026

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