In a six-part series in The National, the economist Omar Al Ubaydli has explained to readers several aspects of wages and the labour market. Today we publish all six articles as one.
Part one: What determines wages in the GCC and elsewhere?
Under normal circumstances, a company agrees to pay you a wage for one reason only: the tasks that you perform generate revenues for the company. It can be direct, such as when a sales assistant sells a company’s product on its behalf; or it can be indirect, such as when an IT technician fixes the computer that the sales assistant uses.
Note that the revenues that your efforts generate are not the same thing as how hard you work: we can all work very hard digging holes but that does not create revenues for companies.
Similarly, not all educational qualifications generate revenue equally: a doctorate in English literature might be intellectually more demanding than an accounting diploma but the latter typically contributes much more to a company’s revenue.
The revenue that your efforts produce for the company places a ceiling on how much it is willing to pay you; if you earned a higher wage than that, then employing you would make the company lose money. That ceiling might be further pushed down by the presence of competing workers: if someone else is willing and able to do what you are offering, but for a lower wage, then the company will not hire you for a higher wage.
On the flip side, most tasks you offer to do for a company are inherently unpleasant compared to watching television or reading a book, and so you are only willing to do them if the compensation is sufficiently high. And the floor in your wage demands for a certain position rises when another company is willing to pay you more for the same job.
The wage that you end up earning will lie somewhere between the company’s ceiling, which is a function of your productivity, and the ease with which the company can find someone else to do your job; and your floor, which is a function of your alternatives to working, including leisure, and the amount that others are willing to pay you to do the job.
Thus, if you think that a certain job pays a lot less than is fair, then that is most probably because of a combination of two reasons: first, the tasks performed by the worker do not create substantial revenue for the company; and second, lots of people are willing and able to perform the job at a low wage. That is why nurses earn such modest wages, despite the fact that they save lives. Conversely, cosmetic surgeons earn high salaries because they generate a large revenue for the hospital, and because very few people have the necessary skills.
Similar factors explain cross-country wage differentials: the reason that a programmer working in the US earns more than one working in India is that the US-based one is much more productive – he or she has access to superior software and the company is producing output that is much more valuable – and because the Indian-based programmer faces a lot more wage competition from other programmers.
Do notions of fairness ever matter for wages? Typically, no, unless they affect productivity directly. For example, having large wage differentials within an organisation might damage morale and therefore lower productivity. That is one reason why companies prefer to keep wages secret!
The GCC is special because the governments employ more nationals than do businesses. Most public sector organisations, such as police forces, do not have a conventional revenue, meaning that managers have much more discretion in determining what pay an individual merits.
Moreover, one of the governments’ explicit goals is to raise its citizens’ living standards by providing them with secure jobs, even if their pay might exceed what can be justified by the market value of the tasks being performed.
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Part two: What is the human capital model of education, and how does it affect wages in the GCC and beyond?
Throughout most of human history, economists considered education a purely intellectual pursuit. Students at higher education institutions such as Oxford University were considered the representative case: independently rich, and studying disciplines with little or no labour market value, such as theology. The fact that wealthier countries had more educated populations was attributed to education being a luxury that only the rich could afford, rather than because education was a contributing factor to economic prosperity.
After the Second World War, a group of economists, including Jacob Mincer, Gary Becker, Arthur Lewis and Theodore Schultz (the last three of whom went on to win Nobel prizes) proposed a different interpretation for education, popularising the term “human capital”. Rather than analysing education as an intellectual activity unrelated to labour productivity, they treated it as an effort that an individual makes to enhance their abilities, including those of interest to employers.
As mentioned in Part One above, a key determinant of your labour market compensation is the degree to which the tasks that you perform increase the company’s revenues. Education is therefore considered a way to improve your ability to generate revenues for firms. A doctor cannot earn their hospital money unless they have acquired the medical knowledge necessary to treat people, just as an architect cannot create designs for buildings that their employer sells without learning how to construct aesthetically pleasing buildings that do not collapse.
The reason for the term “capital” in human capital is that it is considered an investment: the investor bears an upfront cost, comprising tuition fees and forgone labour market earnings due to being enrolled in full-time education, in exchange for a delayed return, which is higher labour market earnings after graduation.
Different types of human capital vary in their labour market value, depending on the availability of other people with the same human capital, and the revenue-generating effectiveness of that human capital. Thus, some investments, such as a PhD in art history, offer a very poor, and likely negative, rate of return, compared to a bachelor’s degree in mechanical engineering. However, the human capital model does not purport to be the only explanation for education: economists still acknowledge the direct enjoyment benefits associated with certain educational qualifications, such as a filmmaking degree.
Advances in data availability have allowed economists to study the relationship between income and education, partially as a way of testing the human capital model of education. Statistical modelling has provided strong confirmation that individuals and countries with higher levels of education also exhibit higher income levels.
Within the GCC countries, the relationship between income and education is standard, in that better-educated people have higher labour market earnings than their lower-educated brethren. However, at the country level, the GCC countries constitute an outlier in global comparisons, because income is much higher than would be predicted given the educational attainments of their people. Naturally, the primary reason for this is that the GCC countries are endowed with very large volumes of hydrocarbon resources, which generate income without requiring educated workforces.
The conviction that education improves abilities and hence income has driven many economists to support public subsidies to human capital accumulation. The abundance of free education across the world, sometimes even up to the PhD level, confirms that policymakers have been convinced by such arguments.
However, there are two potential flaws with such a plan. First, as mentioned above, many educational qualifications are of no consequence to an individual’s ability to deliver valuable services to others, or to contribute to a firm’s revenues. Second, identifying these “dud” qualifications is very difficult, because labour markets are highly dynamic. That is why all governments, including the GCC, should tread cautiously when considering educational subsidies, lest they create white elephants.
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Part three: What is the signalling model of education, and how does it work in the GCC and beyond?
The human capital model of education, developed in the 1950s, analysed education as a way of building valuable skills. It provided economists with an intellectual foundation for treating education as a source of wealth, paving the way for the big expansion in higher education that has happened in advanced economies since the 1970s.
An alternative, complementary assessment of the role of education, known as the signalling model, was proposed by the American economist Michael Spence in the 1970s.
In its simplest form, the model says people differ in their ability to perform revenue-generating tasks for employers, just as in the human capital model. The problem faced by firms at the hiring stage is that they can only imperfectly determine people’s innate abilities; tests and interviews help, but a significant part of how good you are at your job is unknown to an employer.
Unlike the human capital model, education, most notably university education, has no effect on your ability. However, people who have high ability in the labour market also find it easier to score high GPAs, and to generally excel at college, because certain attributes, such as intelligence and perseverance, make you an effective student and an effective worker. Therefore, people invest in educational qualifications as a way of credibly “signalling” their innate abilities to prospective employers, rather than to acquire skills that can be deployed in the labour market.
According to the signalling model, a top management consultancy might prefer to hire a Harvard anthropology graduate over a business major from a lower-ranked university because the Harvard student is more likely to be intelligent and perseverant, despite the fact that 95 per cent of the skills acquired from the anthropology degree are of no relevance to management consulting. According to a pure form of the human capital model the business major might have been the preferable choice, because of their relevant skills.
Naturally, advocates of the signalling model do not think that all education is signalling; for example, doctors clearly acquire critical knowledge during their medical degrees. However, the signalling model provides an explanation for why the labour market places such a high weight on education.
Thus, according to the signalling model, individuals who have higher education earn more, but at the country level, the relationship should be much weaker, because education is merely sorting people into the right jobs, rather than contributing to people’s productive abilities.
There is some evidence that the economy-level returns to education are exceeded by the individual-level returns, and it is clear that some mixture of the signalling and human capital models underlies true labour market dynamics. Correctly assessing the contribution of each model is of great value, because the greater the importance of signalling, the less effective are government subsidies to education.
For the GCC, as we mentioned in Part Two, the large public sector pays nationals wages that are incommensurate with their productivity, partially as a way of raising living standards.
This distorts the relationship between education and income: more educated people receive higher salaries because they have acquired more skills through their education (human capital model), because their credentials signal higher innate ability (signalling model), and also because government pay structures arbitrarily assign higher salaries to people with higher education levels, regardless of any relationship it might have to innate or acquired skills.
This makes it more difficult for policymakers to infer the right level of education subsidies, as interpreting the observed relationship between income and education is even more complicated than in a traditional economy.
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Part four: Do migrant workers depress local wages in the GCC and beyond?
The two biggest electoral shocks this year were unquestionably the UK’s decision to leave the European Union, and Donald Trump’s victory in the US elections. A key issue among voters was the perception that migrant workers depress the wages of low-skilled nationals, because of their willingness to work for a lower wage.
This sentiment is shared by the citizens of many countries that receive migrant workers from developing economies, including the GCC countries. In fact, employers who hire migrants at supposedly lower wages are often accused of exploitation. Are these criticisms well-founded?
Unfortunately, it is very difficult to say, because there are two counteracting forces, one of which is hard to measure, and the other that is almost impossible to measure.
The first force fits in with the traditional narrative, and amounts to a straightforward application of supply and demand theory. Labour is like any commodity: increasing supply means decreasing prices (wages in the case of labour), whether it is chief executives, janitors or chefs. Moreover, if the new entrants are willing to work at a lower wage, then that accentuates the downward pressure on the market wage rate.
No economist will argue over the existence of this direct effect. But that is only half of the story.
The second force is a series of increasingly complex indirect consequences resulting from cheaper labour entering the market. First of all, at all levels of the skill ladder, a worker’s productivity is not just a function of their own abilities, it is also a function of the abilities of the worker’s colleagues. Infusing the workplace with migrants changes the prevailing configuration of workers; given that firms are free to hire and fire migrant workers, they will only actually offer them employment if they raise productivity in some sense.
A good illustration is farm workers in the US. It is possible for American farmers to employ US citizens to pick fruits during harvest, but the wage would be very high, meaning higher prices for consumers, lower profits for the farmers and much lower output because of the elevated costs. Allowing migrant workers from Mexico to work means a lower wage, but it also amplifies the farmer’s productivity, allowing for much larger output.
The productivity gains extend beyond a specific workplace, too. In the GCC, migrants working as domestic helpers for low wages dramatically increase the productivity of parents working as professionals, such as lawyers or doctors, who might otherwise have to be stay-at-home parents.
The effect becomes even more complex when one accounts for the knock-on price effect. The US citizen who can buy cheaper oranges has more money to spend on other goods and services, implying an increase in living standards. The same is true of the Kuwaiti lawyer who need not stay at home. Moreover, as the savings are directed toward other goods and services, wages will increase in those sectors.
After this convoluted mixture of effects settles, which force wins out? Lower living standards for low-skilled citizens because of the increased competition, or higher living standards because of lower prices and more productive workplaces? The impossibility of measuring the latter component means that there is no definitive answer, but it also means that we should not sloppily fixate on the first part just because it is easier to detect.
As policymakers seek to gather high quality data upon which to base their decisions, it is worth emphasising that the question that should be posed is not: “Did your wages fall due to migrant workers?” Rather, they need to ask: “Is your overall standard of living higher due to migrant workers?” It is possible for both to be simultaneously true, in which case we should certainly embrace migrant workers.
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Part five: What are the costs and benefits of minimum wages in the GCC and beyond?
After the 2008 global financial crisis, government austerity in countries the world over, including the GCC, have made ordinary people very cognisant of wage determination and there are regular calls for a higher minimum wage as a way of helping low-income groups.
The primary factors that govern a worker’s wage are the worker’s ability to generate revenue for the company and the degree of competition from other workers. Sometimes, this organic wage determination process results in a wage that society regards as “too low to make a living”, leading to calls for a minimum wage.
Economists associate two primary downsides with minimum wages. First, they can undermine the interests of the precise group they are intended to assist, primarily by decreasing demand for low-wage workers. The wage is the price of labour and if it is forcibly increased, demand for it should contract, just as it would for apples.
This backfire can be especially damaging for the young, whose lack of job-relevant experience means they can only earn low wages; under unrestricted labour markets, as they build their resumes, their productivity increases, and so do their wages. Enforcing a minimum wage may price some of them out of the market. Moreover, it can accelerate the speed with which robots and self-service kiosks are deployed as a replacement for low-skilled labour. This is one of the explanations offered for high youth unemployment in Europe, where minimum wages are high by international standards.
The second downside is that minimum wages hurt the companies that are forced to bear higher costs. Proponents of higher wages often envisage giant corporations such as Microsoft, that distribute billions of dollars of profits to their wealthy shareholders, as being the archetypal “loser” from a minimum wage, a scenario in which they regard minimum wages as a transfer from satiated fat cats to the needy poor.
In fact, in most countries, the largest share of employment comes from small- and medium- enterprises (SMEs), which make limited profits. Minimum wages will hurt their bottom line, and will limit their growth, which otherwise constitutes a key source of job opportunities.
One alternative to a minimum wage that yields the same upside, while largely eliminating the downsides, is means-tested income support, whereby the market determines wages without restriction but the government “tops up” the wages, possibly to the level associated with the proposed minimum wage. By funding it from general taxation, it limits the effect on SMEs; and by letting the wage employers pay be determined by the market, it eliminates the backfiring effect from low-wage workers being hired in smaller numbers.
In the GCC the labour market looks different because the government sector, and not SMEs or large corporations, is the largest employer of nationals and wages often exceed what can be justified by the market value of the tasks workers perform. In this situation, raising the minimum wage is largely similar to the alternative of the government topping wages up because the government can commit to not cutting employment, unlike a profit-maximising company would. As a result, in the GCC, the traditional drawback of a minimum wage is smaller than in a conventional economy.
This option is feasible and possibly even desirable when governments are so well resourced because of, for example, oil revenue that they can afford to pay exuberant wages. Yet, these are rare circumstances and as the GCC countries are seeing, they can be transient too. Therefore, it is important for policymakers the world over to appreciate that minimum wages are not the Robin Hood policy their proponents perceive them to be; they can hurt many stakeholders, including the ones that they are designed to help.
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Part six: Do employers worry about fair wages in the GCC and beyond?
One salient difference between economists and non-economists is that the latter are often observed describing prices, including wages, as being “fair” or “unfair”, whereas economists will scarcely use such terms.
In fact, laypeople will often demand that the side that is benefiting from an “unfair” price change it in the interests of fairness; for example, demonstrators frequently insist that companies such as Nike pay higher wages to their employees in developing countries.
The reason that economists shun such terminology in the context of labour markets is that according to economic theory, backed by rigorous statistical evidence, the major determinants of wages are the worker’s ability to generate revenue for the company and the competition between workers for the job.
If you want to get a raise, rather than claiming to your HR director that your current remuneration is unjustly low, economists would urge you to either obtain a superior outside offer, which you can use to bargain for a higher wage, or to demonstrate to your organisation that your work is creating higher revenue for it than before, or than it currently perceives.
Like all models, be they in economics, geology or medicine, the traditional labour market model does not apply perfectly to all situations and economists have identified important settings where perceptions of fairness have a significant impact on wages.
Humans exhibit an acute aversion to having their wages decreased, even if it is by a small amount. In contrast, having wages increased by a comparable amount has a much more modest effect on a person’s disposition. Moreover, raising the prices of important commodities while keeping someone’s wage fixed, thereby lowering their effective (real) wage, is deemed much more acceptable to workers than a direct wage cut, even if the two might have an equivalent effect on living standards (this is known as “money illusion”).
As a result, companies take great care to avoid cutting wages. For example, managers may prefer to lay off 10 per cent of employees than keep everyone and cutting wages by 10 per cent, because they fear the demotivating effects of the latter option.
Another area where perception is significant is wage comparisons. Once inside an organisation, workers are averse to large compensation differences within teams because of humans’ built-in tribal mentality.
If a manager is considering replacing an existing worker with an outsider willing to do the same work, but for a lower wage, then the manager will hesitate for two reasons: first, the other team members will be angered by what they perceive to be a mercenary act of disloyalty toward the incumbent; second, once the new arrival acclimatises and realises that others are paid more, he or she may also rebel.
In the GCC, fairness perceptions can have a different effect due to the prevalence of public sector work, where salaries are determined by factors other than a worker’s productivity, including the government’s desire to provide secure jobs to its citizens.
In particular, once an employer overtly acknowledges that factors other than the organisation’s bottom line will play a role in wage determination, workers will vociferously appeal to fairness considerations during wage negotiations, as they seek to exploit the manager’s humanity. Anticipating this, civil service bureaus preemptively devise highly rigid wage structures, effectively tying managers’ hands.
Closing one door, however, merely motivates workers to look for a different one and that is one reason why senior GCC policymakers, who do have the power to override rigid wage structures, might find themselves being petitioned by waves of government employees wanting wage increases. And as Victor Hugo remarked: “Being good is easy, what is difficult is being just.”
Omar Al Ubaydli is the programme director for international and geopolitical studies at the Bahrain Center for Strategic, International and Energy Studies, and an affiliated associate professor of economics at George Mason University in the US.
business@thenational.ae
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