Labour Economics Reservation wage

by paulali1989 (student)

University Degree Business and Administrative studies

Labour Economics

In this essay my aim is to provide a concise explanation to what the reservation wage is. I will firstly provide information on the term reservation wage, moving on to examples of how different people will have different reservation wages. I will convey information on each example adding possible variables which may affect their reservation wage. Then lastly I will conclude by using the information on reservation wage and different examples to conclude what I’ve learnt.

What is the reservation wage?

In simple terms this is the lowest rate at which a person will participate in the workforce or highest rate at which an individual chooses not to work. (Contemporary labour economics 4th edtition McConnell 1995)This may sound peculiar but there in fact many reasons why a person chooses not to participate in the workforce. We are assuming the world is indeed full of rationale people. If a person receives a higher income without participating in the labour force why would he work? The person may have an inheritance, professional gambler or lack the skills to gain employment which pays more than the welfare system. There many variables which affect a reservation wage someone’s age, sex, location, health and disability

When talking about the reservation wage it is important to remember the compensating differential theory. This affects the reservation wage; this is the amount of extra income needed to motivate an individual to work in an undesirable job. Or indeed can be about an individual taking less income to work in a desirable job. A real life example two of my friends from school, two qualified electricians, same age, similar qualifications and the same amount of work experience. One friend works on an oil rig. He works long hours, stuck in the North Sea weeks at a time and has an element to danger to his job. He works as an electrician there getting paid abnormally high wages; his surplus value would be immense. On the other hand my other friend works as an electrician in a food manufacturing plant. He has flexible hours, works shorter days, job security he works in a thriving industry and works in his hometown with friends but does not earn as much as he would if he were to work in construction. The tales of my two friends are the perfect example of compensating differentials affecting their reservation wage.

How would you expect the reservation wage to be affected by a person with a history of high unemployment?

This is a preview of the whole essay

How would you expect the reservation wage to be affected by a person with a history of high unemployment?

If we look Keynesian economics we’d see that wages are sticky downwards. The person is unwilling to take a lower wage due to human stubbornness, labour unions or self-interest. The consequence in the short run leads to shifts of supply and demand in the Short run. Unemployment rises and in the long run wages and prices are adjusted and eventually the economy gets back to equilibrium. This is indeed a common problem in today’s society as it is common from workers being laid off one symptom of a depression. A possible cure menu costs is a change in supply or demand in a firm to adjust prices, money elusion try convince people to think of currency in nominal value or perfect information which is indeed next to impossible, all firms to know everything about competition is unrealistic. On the basis of Keynesian economics this person reservation wage would remain high. If this person was to be very skilled and experience, they may receive a number of wage offers and use their bargaining power for a higher wage.

Another economic belief is that regions will converge. In theory London becomes too expensive for firms to be based there. They move to cheaper regions more jobs come to that region making it more desirable. If this person with the high wages where from London he would simply move to were his real wage was similar. In the north of England homes can be around 70% cheaper than in London. If this person was offered a position with 20% income decrease its still feasible for him to accept this. The lower house prices and lower cost of living makes up for the pay decrease, so in theory his real wage may of even increased by taking a pay decrease. This person would have had a lower reservation wage than before.

How would you expect the reservation wage to be affected by a person with low qualifications?

If this person was a classical libertarian he would be willing to take a pay decrease. It would be his opinion that unions were not doing him any favours by introducing a minimum wage. Jobs are heterogeneous. They different skill levels for different jobs require different pay. They would be willing to work for a low wage. With bargaining they could get employment, acquire knew skills become more productive and earn a hirer wage. If firms were to follow the screening hypothesis then unskilled workers would almost be condemned to a life of poverty. If labour is demand derived a person’s marginal productivity would need to be higher than his wage

He would receive a minimum wage. This person may need a higher wage than the above example as its need to be viable for him to work. The person needs to insure that working this job means he earns enough to pay his rent and provides enough disposable income to maintain the same standard of living they had whilst relying on welfare. This person would require a higher reservation wage than the above.

How would you expect the reservation wage to be affected by a person with pre-school children?

It’s possible this person would require a high reservation wage. The person would require enough income to cover nursing costs for when they are working. Once that has been paid there must be enough disposable income to cover other living costs. If benefits cover all of them expenditures than there is no real incentive to work, hence they would have a high reservation wage.

It is also possible this person requires a low reservation wage if the welfare doesn’t adequately cover their costs. This person would have a lower reservation wage as currently they aren’t living a comfortable lifestyle and need extra income. One key factor to them is flexibility having small children. A negative compensational differential would be prevalent. The person would take a lower income for a desirable job, i.e. a job which gives them flexible hours.

How would you expect the reservation wage to be affected by a person who has been unemployed for more than six months?

Usually the longer you have been employed the harder it is to find employment. This suggests to me this person’s reservation would be low. I’m going to assume they’ve been searching for work but their marginal productivity doesn’t yield enough to warrant them being paid the minimum wage. The person may also been out of employment due a dependant whether it be a child, elderly or disabled person. The person may not wish to return to the workplace. This person enjoys they work they had done in the past; they would have a low reservation wage as they want to return to the workplace.

The person’s length of time out of the workplace could also be because they have a high reservation wage. This could be a very skilled or experienced person, they could have had enough capital to fund living costs and fund a job hunt out of the workplace. This person’s reservation wage may of indeed rose since leaving the workplace. It’s subject to his expected wage and the quantity of wage offers he receives. If his old workplace wants him back, yet he has had wage offers from other firms he can use his bargaining power for a wage increase.

How would you expect the reservation wage to be affected by someone who has reached retirement age?

This person’s reservation wage follows the trend of the others it could be high or low. If the person had mandatory retirement at 65 and is in good health he may have a low reservation wage. There are numerous reasons why his reservation wage could be low. He may feel in good health and feel he can still contribute. They may of worked in the same job role for many years and enjoyed it. The main example in my mind is football. The majority of footballers become coaches and managers. Maybe it’s due to the short time scale of there playing career or perhaps because they have trained since they were kids the job has become part of their personality. These type of people would require a lower reservation wage.

The person may also have a high reservation wage as the person gets older leisure time becomes more valuable usually. This person may of retired due to ill health this person would usually require a high reservation wage for them to sacrifice leisure time for work. The person may off been planning retirement for many years. They may have aspirations to carryout which weren’t possible whilst they were working. Now they have retired it’s become possible this person would require a higher reservation wage.

To conclude I have learnt that the idea of a reservation wage is quite simple. It is the lowest amount of income someone is willing to work for or highest amount someone will remain unemployed. The thing I’ve taken away from this assignment is how much it varies from person to person. I’ve taken examples of people knowing only one variable, in theory it’s affected by not just one variable but a variety. The reservation wage is generally subject to diminishing returns whilst searching out of the workplace with a few exceptions. To draw a real life comparison of what I’ve said I’m using my friend. A graduation in a specialised environmental course this niche course had very few job opportunities. My friend’s job search started along the lines of graduate jobs but slowly they became more infrequent and eventually he accepted a retail job. Hence diminishing returns in one period of his search he wouldn’t accept that job, with time he accepted it. As I pointed out above with the retired person it’s possible that there reservation wage will remain high or even increase especially if they are in ill health. In this assignment critical thinking and analysis is key. I’ve shown this by taking a number scenario’s and showing how introducing another variable to some changes there reservation wage.