1. Labor as a factor of production
This and the following two chapters will analyze the
three factors of production: labor, land, and capital goods.
Some people prefer the listing and analysis to be in the order
of land, labor, and capital, for the reason that land appeared
prior to human beings or is logically prior. But to understand
the economics of land, we must first delve into that of labor,
since the rent of land depends on the productivity of labor,
hence labor is economically prior to land and capital goods.
Henry George (1879, p. 32) provided a concise yet
comprehensive definition of labor and wages: "the term labor
includes all human exertion in the production of wealth, and
wages, being that part of the produce which goes to labor,
includes all reward for such exertion." This exertion includes
both mental and physical effort, and it encompasses the efforts
of entrepreneurs, managers, and the self-employed. (The
Austrian economist Carl Menger (1871, p. 172) noted that
"Entrepreneurial activity must definitely be counted as a
category of labor services.") "Wages" includes any return or
yield to labor, whether it be a salary, commission, or the
profit of the self-employed. Part of the value of crops grown
by a farmer on his or her own property or the gold panned by a
prospector are wages.
To be meaningful, the concept of labor must be distinct
from capital goods and land. George (p. 39) noted that people
often speak of a worker's skill and knowledge as being
"capital"; economists call these "human capital." But this
meaning of "capital," he noted, is "a metaphorical use of
language," and not to be confused with the use of "capital" as a
resource or factor of production. A human being is different
from a machine or a horse; persons are the subjects, not
objects, of social science. One may consider all inputs into a
productive process as "capital," but then one would still
distinguish among the meaningful categories of such capital, one
of which would be labor, distinct from natural resources and
capital goods.
2. Do wages come from capital?
By contributing to the production of wealth, labor
creates its own income. In the 19th century, political
economists such as John Stuart Mill believed otherwise. Mill,
in his book Principles of Political Economy, developed what was
known as the "wages fund" theory. This was an attempt to
account for the source of wages and the principle by which they
were distributed.
In its crudest form, the theory states that there exists
a fund of financial capital out of which wages are paid. The
formula for this theory is W = K/L. Wages (W) are derived from
the quantity of circulating capital (K) divided by the size of
the labouring population (L). According to this theory, if the
population of the labour force rose, wages would drop as more
workers competed against each other for a supply of fixed
capital.
Population growth rather than institutional factors are
thus portrayed as the cause of low wages and poverty. Also, the
theory that wages are derived from the previous amount of
capital implied that industry or employment is limited by that
capital.
Not surprisingly, economists no longer subscribe to this
theory. One of the first to refute it was Henry George (1879).
He showed that labor creates its own wages from its contribution
to production. When workers are paid in advance of their labor,
this is really an implicit loan paid back by the value of the
labor (George, p. 57).
Yet, despite the inadequacies of the theory, the
assumption on which it is based - that wages are drawn from some
supply of capital - is still implicit in public debate. It
seems to apply when labor struggles with the owners of companies
for higher wages and benefits, but this contest is actually a
game in which labor union leaders try to obtain wages greater
than their marginal product, and the company managers or owners
try to prevent this, or, in some cases, pay them less than their
product. As is discussed later, this contest is largely due to
taxes and other government interventions which make labor
expensive to employers while reducing the wages of employees.
Psychologically, the erroneous idea that wages come from
capital has had ruinous effects: workers have been led to feel
overly dependent on the capitalist, who is given the whip-hand
over labour. The fact that the dependency of the worker and the
control of the capitalist is ultimately linked to the present
tax systems is unrecognized by most.
3. The determination of the wage level
But how does the wage level get established in the first
place. And how does one account for poverty? As Henry George
(p. 205) pointed out, a free man would not agree to work for
another for less than he could secure by working for himself.
So wages are determined by what one could earn from
self-employment elsewhere. But where?
A) Wages from the product of labor
The determination of the wages of different types of
labor are the result of the supply and demand for that type and
quality of labor. In a pure market economy, wages ultimately
reflect the value put on a worker's product by consumers: if
consumers put a low value on his product then his wages will be
low; if it puts no value on them, then his wages will be nil,
and he will have to switch to producing a product other people
want. As George (p. 77) put it, "The demand for consumption
determines the direction in which labor will be expended in
production."
Wages vary among different occupations because what some
workers have to offer is valued more highly than what others
have to offer. In consideration of one particular kind of labor,
if there exists a shortage of labor then through the action of
supply and demand wages for that labor will tend to rise.
Conversely, where a particular labor is in surplus, wages for
that labor will be reduced. The laws of supply and demand
determine the relative wages among different types of labor.
But this still does not tell us what determines the wage
level in an economy. There is a tendency for wages in an area
to be linked together, so that one can speak of wages being
generally high in Japan and low in India. Barbers in the United
States have had a higher wage, even relative to local prices,
than those in Mexico or Latvia, although their quality of work
is similar.
George (pp. 26-7) recognized the "fundamental truth"
that the basic principles of economics evident in a simpler,
primitive, society are still in effect in a more complex, more
developed world. We can discover the principles of wages by
first analyzing a primal economy. Suppose there is a village
that gets its food from hunting and gathering, and that there is
more than enough land and game to support the village. The land
is owned by the village in common, and since land is abundant,
there it no rental value. Suppose also that the village is
really primal, so that they don't have any capital goods - no
tools, like baskets or spears.
If the villagers go naked into the bush and gather nuts
and berries with their bare hands, the only resources are land
and labor. Here we see an economy in its most fundamental form:
a person "endeavoring to obtain from nature by the exertion of
his powers the satisfaction of his desires" (George, p. 27).
Since there is no rent, the fruit they gather is all wages.
Leaving out capital goods for now, what the naked hunters get
from the forest, catching animals with their hands, is also
wages. It is clear here that the hourly wage of the
hunter/gatherer is equal to the produce that one can obtain from
an hour's labor. Also clear is the principle that production
precedes consumption.
When a laborer receives his wages in money instead of
goods, the principle is the same. A worker "really receives in
return for the addition his labor has made to the general stock
of wealth, a draft upon that general stock..." (p. 29). Thus,
money wages too are not an advance but only a claim on the
amount of value one's labor has added to.
George notes, further, that all workers contribute to
the production of all wealth. For example, the person who
repairs fish nets helps catch the fish as much as the ones who
go out into the sea. But the one who made the boat also
contributed to the catch. And so did the one who made the wood
and steel for the boat. Extending this to its logical
conclusion, everyone who labors helped catch those fish. You as
a worker help produce bread and steel by demanding these
products in exchange for the goods you helped to make as well as
by contributing ultimately to the goods that the bread maker and
steel maker need. As George (p. 77) put it, "in aiding in the
production of what other producers want, he is directing other
labor to the production of the things he wants - in effect,
producing them himself."
If we then add tools and buildings and other capital
goods, labor is able to obtain more product, but again, the
portion earned by labor in general will be its marginal (extra)
contribution to the product. If land rent is zero, then since
capital goods are produced by labor, both the tool maker and
consumer-goods maker obtain their wages from their product. In
practice, individual workers might get paid more or less than
the economic value of their product due to personal biases of
bosses, imperfect knowledge, inadequate or superior negotiating
skills, or luck, but the general tendency in a pure market
economy is for wages to equal the marginal product that labor
provides.
Now, perhaps because the forest is destroyed, the
society turns to farming. Each family gets a plot that it
farms. Suppose it can grow 10 bushels of corn per unit of land
per some period of time. They have as much land as they want of
that quality, so rent is still zero. Again leaving capital
goods aside, the 10 bushels grown by a farmer is all wages.
Clearly, wages are drawn from the goods it produces, and in any
particular area, the amount and value of the goods that labor
can produce determines the wage.
The fact that some goods are produced over a long period
of time does not change the principle. As George (pp. 50-51)
notes, if a shoemaker starts with leather and works it up into a
pair of shoes, the labor has gradually added more and more value
to the original capital good, the leather. Hence the wage comes
from the value added rather than from the original capital. As
George (p. 56) put it, "Production is always the mother of
wages."
B) The extensive margin
Suppose now that the most productive land, where farmers
can grow 10 bushels, is all taken up. Farmers will now
cultivate the next best area, which we can consider to be 9
bushel land. Wages at the 9-bushel land is 9. What, then are
wages now in the 10-bushel land? If someone offers a wage of
9.5, all the farmers in the 9-bushel land will come running to
apply. Someone who wants to hire labor only needs to pay 9
bushels. If he offers any less, no one applies, since they can
bet 9 by working for themselves.
If someone owns a farm on the 10-bushel land and hires a
worker instead of working on it himself, that extra bushel
produced after paying 9 to the employee is therefore not wages,
but goes to the owner as rent. So wages in all land is
equalized, due to competition among the workers, and any extra
product goes to the owners of the lands as rent.
The best available land that can be had for free is
called the "extensive" margin of production. It is called
"extensive" because people keep extending or moving it out to
lands of ever lesser quality as the better land gets taken up.
The wage level is determined at the extensive margin, where the
best free land is available. This boundary is also called the
margin or cultivation, or more generally, for lands of all uses,
the margin of production.
It is only when the margin is pushed further and further
away and people are located on worse and worse land that the
base rate of wages will fall. As George (p. 206) stated, "the
wages which an employer must pay will be measured by the lowest
point of natural productiveness to which production extends, and
wages will rise or fall as this point rises or falls." If
people are pushed to production on the land on which one can
barely survive, then wages will be at a subsistence level.
In Great Britain, at the time when people set off to
colonise Australia, wages were low. With labor competing for
limited opportunities and a no free good land available,
employers could afford to offer low wages. However, in
Australia, New Zealand, and America, the situation was reversed.
Land taken from the aboriginal inhabitants was available to
European immigrants, and it had a much higher yield than the
margin in Europe. Therefore, wages for other occupations had to
be high to keep employees.
Suppose in some island all the land gets taken up.
There is no more free land. The margin, however, is still
there, if not for agriculture, then for something else. One can
go to the sea and catch fish in waters where one does not have
to pay rent. In towns, one can add an extra story or build a
two-story instead of one-story building; the margin would then
be vertical space, where the top stories of buildings are
located, since another story can be built without paying any
more for land. There is almost always some type of land,
whether air, water, or surface soil, that is available. If not,
if in some location all lands are taken up and claimed, then
there will still be some internal or "intensive" margin of
labor, as discussed below.
If we now switch from a one-crop economy to many crops,
different products, we see that labor can be used to produce one
or the other. The value of the labor, its wages, will be
determined by the values that the customers and consumers of the
crops place on those products. If one person grows sour apples
and few people want them, then his wage will be low. If there
is a high demand for the good, the wage, over the time of
production, will be high.
Workers will then tend to move from low-paid to
higher-paid products, if they can. If workers are growing
mangos and lemons, and one mango is trading for one papaya, but
it takes twice as much work to grow the papaya as the mango,
the mango growers will have a wage twice that of the papaya
growers. If some workers are willing to switch from one crop to
another, wages will tend to equalize among the crops or, more
generally, among products, resulting in some overall wage level.
More mangos will be produced and fewer papayas, reducing the
relative price of mangos until one papaya trades for two mangos.
Hence, the principle remains the same in complex
production, where we have many products and industries. The
"law of wages," as Henry George (p. 213) called it, is that
"Wages depend upon the margin of production." More generally,
the wage level is determined by the margin of production, that
boundary where the best land can be obtained free of extra rent,
or, if all land is taken, the intensive margin where the next
worker can get the highest wage without having to pay extra
rent.
C) The marginal product of labor
What happens if one of the farm owners that has hired a
worker wishes to hire a second worker? The second one is also
paid the same wage as people can get by working on their own
farms, but is the extra product of this worker the same? We now
turn to the interaction between wages and the productivity of
workers on the same lot of land, or in the same factory or
enterprise.
The "marginal product of labor" is the increase in total
output achieved by hiring one more laborer. If by raising the
work force from 50 to 51 a firm raises total output from 1000 to
1010 units, then the marginal product of labor is 10. The
"value of the marginal product" is the physical marginal product
(the extra goods produced) times the price of the product.
Suppose we have a farm of 100 acres (40 hectares). One
farmer by himself might be able to grow 100 bushels of corn
during a certain time. If a second farmer is hired, the total
product might grow to 240. The marginal product of the second
farmer is 140, since the two can do some things that the first
could not by himself. A third farmer might raise total product
to 350. He adds 110 to product, less that the second, since
there is less marginal benefit from the added cooperation and
work. Although in any particular case, the first few added
workers may each add more to output than the previous,
eventually, the added or marginal product must decline, since
the fixed factor, in this case land, will not yield increased
output forever. This was the third foundational proposition of
economics, as presented in Chapter 1.
The phenomenon of each new laborer (or other factor)
adding ever less marginal product is called the "law of variable
proportions," or, more famously, the "law of diminishing
returns". Eventually, the diminishing marginal product becomes
negative as workers keep getting added to a fixed amount of
land.
This internal margin, or "intensive" margin (since a
given lot of land or a factory gets used more and more
intensively), must equal the extensive margin, due to
competition among workers. In the situation described above,
where all the land is used up or claimed, there would still be
some intensive margin for labor. If the extensive margin became
zero, the intensive margin would normally still be positive, and
would set the wage level. It is possible that due to the high
costs of labor or enterprise imposed by taxes and restrictive
regulations, the cost of labor to an employer can be higher than
the marginal product of labor, so that no more labor is hired,
resulting in unemployment.
When the marginal product is greater than the average
product, it pulls the average up, and when it is less, it pulls
the average down. Therefore, the marginal product equals the
average product when the average product is at its maximum. A
rational producer, who wishes to have as high a profit as
possible, will only hire workers when the marginal product is
less than the average product but still positive.
Getting back to our earlier example, suppose that the
margin of production is still at 10-bushel land, and one of the
owners wants to hire a second worker. If the marginal product
of the first worker is 10 but that of a second worker is only 9,
the owner would not offer him more than 9 bushels as wages. But
no one would want to be a second worker, since one could earn 10
as a first worker on his own land.
But suppose that the population grows and all the
10-bushel land is taken up. The extensive margin moves to the
9-bushel land. The owner will now be willing to hire an extra
worker, and will be especially willing if the margin moves to
just below 9, so he can pay a wage of less than 9 and get some
extra rent. In general, an employer will hire more workers as
long as their marginal product is greater than the wage. Since
the marginal product eventually declines, workers are hired just
up to the amount where the value of their marginal product, that
extra revenue produced by that extra worker, just equals the
wage.
Since a firm will hire labor at the amount that equals
its value of marginal product, and since that marginal product
declines with increasing numbers of workers, a firm's demand
curve for labor for labor is exactly the relation between its
value of marginal product and the number of workers, whether
depicted as a curve in a graph or a table of numbers. The
firm's demand curve for labor will thus slope down, since it
demands more workers as the wage declines.
It should be kept in mind that though conceptually the
demand for labor seems to be a precise thing, in practice the
marginal product is a fuzzy, uncertain, imprecise amount, so the
demand curve or relationship for labor, like any demand or
supply curve, is a fuzzy rather than sharply defined line or
table. Also, as we know, other factors can affect the demand
for a particular worker, such as his looks, personality, ethnic
background, personal relationship with an employer, and just
plain luck! So the equation of wage with marginal product is a
general tendency rather than exact description for every
workers.
What about the demand for labor by an entire economy?
It is the result of the demand for labor by all firms, but this
"demand" itself is derived from productivity, since
self-employed workers are their own demanders. We can envision
a "production function" for the entire economy, i.e. total
output as a function of the number of workers.
Since labor exhibits diminishing returns relative to the
land in any particular region or economy, total output goes up
with increasing labor, but at a slowing rate of growth, each
extra worker adding a bit less to output than the previous.
That extra output is none other than the wage of the extra
worker, so we have a downward-sloping demand for labor as a
whole in an economy, wages declining with increasing labor at
any particular moment. But it is important to note, and note
well, that this is a static relationship between labor and
output. It applies to the amount of labor at any particular
moment in time, not to the addition of workers in an economy
over time, which could also increase the division of labor and
dynamically increase output per worker.
With the overall wage level being set by and at the
margin of production, both extensive and intensive, the range of
wages will depend on the supply and demand for labor of a
particular type, with the demand ultimately derived from the
demand for the product that type of labor produces.
The supply of labor for an entire economy, or the market
supply curve, is the quantity of the labor force (all workers
plus the unemployed who want to work) as a function of the wage
level. In other words, it is a curve showing the number of
workers at each wage level. Its exact shape depends on the
culture and demographics (of age, sex, family size) in a
particular economy. It is possible in some places for the curve
to bend backwards, or be upward sloping at some wage level,
because with higher wages, the workers will not want to work so
many hours, preferring leizure to more consumer goods.
Generally, one would expect the curve to be rather flat
at the subsistence level, since every family needs to eat, up to
the number of families. Then it would slope up as second or
third members of a family are willing to work at higher wages,
and workers are more willing to work overtime or take less
leisure. But then at a very high wage, the curve would become
very steep, vertical, and then slope back as workers have a
greater marginal desire for leisure time rather than more goods.
As with any market, the wage level would be determined
at the intersection of the market supply and demand curves.
With that type of market supply curve for labor, wages would be
high if the demand curve crosses it at the steeply rising area.
This would occur if the marginal product of labor is high to
begin with, in which case the supply curve would become steep or
vertical after all families have applied their labor.
Increasing demand for labor, or productivity, would only raise
the wage without increasing the labor supply much. But if the
demand curve for labor hits the supply curve at the horizontal
section, then an outward shift (increase) in demand would
increase employment without increasing wages.
4. How to create unemployment and impoverish workers
The above analysis assumes that there is no tax on
wages. If wages are taxed, then the worker receives a lower net
wage, so if the supply curve is sloping up, then there will be
less labor supplied, since the worker responds to the take-home
wage net of taxes. Thus, a tax on wages, such as a payroll or
income tax, shifts the supply-of-labor curve to the left. As
the supply curve shifts up along the demand curve, this
increases the cost of labor to the employers. Employers must pay
the gross wage, including the tax. The result is less
employment at a higher cost to employers, and a lower net wage
for workers. The tax is a "wedge" between the net and gross
wage, which distorts or skews the market wage to employers and
employees from what a pure market would yield.
To see the effect of taxes on labor, suppose there were
a tax of $1 million per worker. Almost all workers would be
thrown out of work, including the self employed. The effect of
a smaller tax is the same; the difference is only in degree.
The higher the wage tax, the less employment.
Henry George (1883, p. 152) stated, "The essence of
slavery is the robbery of labor." With chattel slavery, as
existed in the 19th century and earlier, the slave owner
expropriates the product of the slave's labor, beyond what the
slave keeps to live on. "Free" labor has a choice of whom to
work for, but if wages are taxed, labor is also robbed, the
worker being a "wage slave." It is not working for an employer
that makes a worker a slave, since in a free economy, he has the
option of working for himself. Rather, it is being forced to
work for others to the extent that part of one's wages is
forcibly taken by government.
Another type of intervention in the labor market is
minimum wages. If the minimum wage set by the government is
higher than that of a market wage level, the quantity supplied
of labor is increased, since more people want to work, while the
quantity demanded is decreased, since labor is more expensive.
The result is an excess or glut of workers wanting to work but
not finding it: unemployment. Minimum wages affect teenagers
and those wanting to enter the labor market especially, since
they are unable to get entry-level work that would give them
experience to enable them to get better jobs later.
Thus, if a government wants to reduce employment and
keep workers unemployed, a good way to do this is to tax labor
heavily and also enact a minimum wage, in addition to
restricting entry into some types of occupations. This has been
the policy of the U.S. and other governments, and it has been
quite effective in keeping many workers poor and unemployed.
5. Labor Unions
Low wages and bad working conditions are two reasons why
labor unions have organized. Trade unions arose out of the
conditions of the labor force during the Industrial Revolution.
Workers could gain bargaining power through collective action,
of which the most potent weapon is the strike. Unions also
became mutual aid societies, offering various services to their
members.
Unions can be effective in giving laborers more
bargaining power in a particular industry, but they cannot
change the overall wage level, since, as discussed above, that
level depends on the margin of production, which cannot be
increased solely by the organizing of labor. If an economy is
divided into two labor sections, one with unions and the other
without, then if unions raise the wages of workers in one
industry, they reduce employment in that industry. The workers
thrown out of work will then move to the non-union section,
increasing the labor supply and so decreasing the wage level in
that section. Thus the effect of the union will be to transfer
income from the non-union section to the union section. The
pushed-up wages in unionized industries also increase the prices
of those products, decreasing the quantity bought, so part of
the cost of these union wages are borne by consumers (as
cost-push inflation) and part are borne by the owners of the
enterprise as lower prices for their stocks.
When, as in some states and industries in the U.S.,
unions have the legal power as a "union shop" to force all
workers in an industry to join the union, they obtain monopoly
power, enforced by its ability to strike. Such unions have
shifted the supply of labor in their industry to the left,
increasing their wage while reducing output and employment by
restricting entry or setting wages above the market rate. Some
have shifted the demand for labor out artificially by forcing
employers to hire workers whose marginal product is less than
the wage, a practice called "featherbedding." In either case,
labor unions have monopoly power backed by the state, increasing
the costs of that industry, with a loss of output and
efficiency.
This does not mean labor unions are harmful in general,
only that they reduce employment and output when they have a
legally enforceable monopoly power. Labor unions can and have
been useful in organizing social benefits for their members and
in serving as a way to communicate in an organized way with the
management of enterprises to negotiate better working
conditions. But unions by themselves, whether voluntary or
coercive, cannot raise the overall wage level or decrease
unemployment. As analyzed above, the way to maximize wages and
employment is to remove the barriers, wage controls, and tax
costs imposed on labor.
But this still can leave the wage level low if the
margin of production is at a low level while much of income is
going to the owners of land as rent. An example of this
relationship is illustrated by the history of Australia in the
next section.
6. The relation between land and labor
Let the "exploitation of labor" mean 1) reducing the
wage level below that which would occur in a pure market
economy, or 2) control of the conditions of labor beyond that
which would occur in a pure market economy. Clearly, slavery is
an example of exploiting labor. Any taxation of wages also
exploits labor. But labor can also be exploited when economic
policy creates an artificially high amount of unemployment,
shifting economic power to employers, and also when government
grants subsidized protection to large landowners who are granted
the privilege of keeping the generated rents, and workers are
thus denied an equal access to the benefits of natural
resources.
7. Raising wages through education
As noted above, "human capital," education and training
which increases the productivity of labor, is part of the labor
factor rather than being a capital good. The general wage level
is based on that of unskilled labor. Workers obtain a wage
premium above the unskilled wage level for their skill, talent,
charm, and personal connections, and the scarcity of workers in
the field. There can also be premiums or discounts due to
discrimination and legal restrictions.
An individual worker can make himself more marketable
relative to others by increasing his skill, including his skill
at job finding. But when most workers attain similar skills,
the comparative advantage of the skill will be lost, although
there will still be an absolute advantage in being better
trained. As we know, for education to increase productivity, it
needs to be geared either to general skills such as reading and
writing, or to the specific requirements of a field. A general
education is also useful over the long run both for personal
consumption, to better enjoy life, and to be a useful citizen.
Education presumes the freedom to make use of it. When
opportunities are blocked off, education makes a person
frustrated. In some less-developed countries, young people
obtain a university education and then find no job
opportunities, other than the civil service, which expands to
give them jobs, but without any productive purpose. In a free
society, employment opportunities are abundant, and education
does not need to be subsidized, since families can afford to pay
tuition. Enterprises seeking skilled workers also offer training
and scholarships. If government schooling is still provided, it
is in equal competition with private schools, and this market
competition maintains the quality of the education as well as
providing different cultural settings. In a multicultural
society, the problem of what to teach is resolved by the freedom
to start new schools that offer education geared to the
interests of the students and parents. Competitive schooling
not only provides training and knowledge, but also preserves the
cultural capital that is part of our diverse heritage.