Economy & Budget

Falling unemployment leads to rising wages, right? Not so fast.

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The unemployment rate remains below 5 percent in the United States. Will pay rates increase as domestic businesses compete for available skilled workers? How will employer responses affect employees? The answers may depend on the nature of the business, the industry, the types of jobs, the human resources strategy of top management and many other factors.

Obviously, these questions are answered differently in different countries; for example, in several western European countries, there are more legally mandated benefits and job security protections. It is a different case in the United States, however.

{mosads}Raising pay is not the only option employers may use in the face of a tightening labor market. In 1975, Dr. Lester Thurow, the late Massachusetts Institute of Technology economist and dean, noted that many employers do not adjust for shifts in labor supply and demand by changing wages.


He argued that the relative pay of a given occupation typically would change only over the very long term, in response to chronic labor shortages. Instead, when faced with a labor shortage at the current wage or salary rate, employers tend to lower their hiring standards and provide more training, rather than raise wages or salaries.

For example, the employer who once recruited only at a handful of elite universities, or demanded 3.5-or-higher GPAs, may cast the recruiting net more broadly, considering graduates from more schools with a wider range of GPAs, rather than raise pay significantly. Likewise, employers using this “job competition model” would raise hiring standards when there are plenty of highly qualified job applicants, rather than lower pay.

Thurow argued that employers change hiring and training, rather than pay, in the shorter run, because many types of knowledge, skills, and abilities (KSAs) essential to success in a particular setting do not transfer across employers (or occupations or industries), or cannot be fully trained in universities. So, as job requirements grow more complex, workers are less interchangeable.

Therefore, the employer must invest in on-the-job training of newcomers and in retaining experienced employees who provide that training. Hiring predicts who might require the least training and learn most quickly. Employers realize that cutting trainers’ pay, when talented potential newcomers are plentiful, undermines the employer’s own objectives, because it disincentives experienced employees to train others well.

We can see many examples of employers using this job competition model today, such as Google, a company that invests heavily in sorting through the huge number of talented applicants, while also offering high pay, training and desirable benefits.

Raising pay in response to labor shortages may be more common and more effective where jobs require fewer KSAs. In today’s economy, with increasing skill and knowledge complexity, workers are not easily substitutable. Years ago, an employer who needed more clerical workers or house painters might have offered better pay and benefits than retail stores competing for the same labor, and then provided the relatively limited training needed.

An employer today who needs a website designer, financial analyst, or human capital planner may not be interested in trying to convince a high school math teacher to change professions, because the KSAs do not transfer readily. Offering higher wages may work more effectively in lower skill jobs than in those requiring specialized skills.

An hourly pay raise that may seem small to highly paid employees can make a dramatic difference to fast-food workers, who can spend that extra money on necessities or save for textbooks, technology or travel. In this instance, a wage raise may attract many new applicants.

Greater use of contracted workers may not enable firms to cut costs at all, or may have unintended negative consequences for employees and for the employer. In today’s “gig economy,” some employers may increase their use of contracted and part-time workers in response to greater needs, hoping to keep costs lower, e.g., by not paying benefits. However, at least three consequences may be problematic for the employer:

  • There may be legal and financial complications if employers misclassify someone as a contractor who is actually an employee.
  • Organizations may pay more, rather than less, in compensation and other costs when they hire contractors. For example, some research suggests that the federal government pays service contractors “at rates far exceeding the cost of employing federal employees to perform comparable functions.”
  • Third, as Thurow’s job competition model implies, there are many situations where temporary employees may not have the KSAs needed and where overreliance on contractors may undermine the training function. Further, there is considerable research suggesting that where employees are demoralized or feel unfairly treated, they tend not to go “above and beyond” in their commitment to their employers. Some may even unionize. If employers are not committed to their employees, why should employees commit to their employers?

There can be substantial benefits to both employees and employers of investing in employees. Where real compensation increases, whether in salaries, wages, benefits or other forms, there are often concomitant benefits for employers as well as employees. Efficiency wage theory proposes that employers who pay higher rates and manage effectively can remain competitive.

They can attract and keep higher quality people (thus also reducing hiring and training costs) who require less supervision. Those employees may work harder because they want to keep their jobs at a desirable place to work and to continue to grow and develop. For example, retailers like Trader Joe’s and Costco “create a virtuous cycle of investment in employees, stellar operational execution, higher sales and profits, and larger labor budgets.”

Looking ahead, we will see a variety of responses to changes in labor markets in the coming years.


Marcia Miceli, D.B.A., is a professor of management at Georgetown University’s McDonough School of Business.


The views expressed by contributors are their own and not the views of The Hill.


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