Economics (McConnell), 18th Edition

Chapter 13: Wage Determination (+ Appendix)

Origin of the Idea

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Joan Robinson (1903-1983) developed the monopsony model. While others in the field of imperfect competition were focusing on the monopoly power of sellers, Robinson developed the model for a single buyer. She developed the graphical textbook model of how a single hirer of labor could pay a lower-than-competitive-wage and still attract the profit-maximizing quantity of labor.

As an economist, Robinson had an eclectic career. Not only did she address a wide variety of issues, her philosophical approach to economics changed dramatically. Robinson started her professional life as a neoclassical economist, studying under Alfred Marshall at Cambridge University. As her career progressed, she became a contributor to the more liberal Keynesian economics and ultimately to the somewhat radical post-Keynesian economics.

In addition to her theoretical contributions, Robinson actively engaged in the formation of public policy. In order to combat low wages and lack of bargaining power in monopsony markets, Robinson and her theories supported a number of laws friendly to labor. Three of particular significance was the Wagner Act (1935), which promoted the growth of labor unions; the Robinson-Patman Act (1936), which protected small sellers from the monopsony power of large buyers; and the Fair Labor Standards Act (1938), which established the minimum wage.

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The idea that knowledge and skills possess economic value is not new. Since the time of Adam Smith (1723-1790), economists have recognized that acquired abilities and improved health affect productivity, output, wages, and more. The first to formalize this idea into a theory of human capital was Theodore Schultz (1902-1998).

Schultz spent his childhood in Arlington, South Dakota. He received his undergraduate degree from South Dakota State University and his Ph.D. from the University of Wisconsin. In 1930 he began teaching at Iowa State University, and in 1943 moved on to the University of Chicago. Schultz was a prolific author, writing 13 books and more than 250 articles, most of them in the areas of agricultural economics, economic growth and development, and human capital. Schultz won the Nobel Prize (along with Arthur Lewis) in 1979 for his contributions in these areas.

To emphasize the importance of investment in human capital in understanding economic performance, Schultz wrote:

This knowledge and skill are in great part the product of investment and, combined with other human investment, predominantly account for the productive superiority of the technically advanced countries. To omit them in studying growth is like trying to explain Soviet ideology without Marx.(1)

Another contributor to human capital theory was Gary Becker (b. 1930). Born in Pottstown, Pennsylvania, he received his undergraduate education from Princeton and his Ph.D. from the University of Chicago. He taught for 12 years at Columbia University before returning to the University of Chicago in 1970 to become a professor of economics and sociology. Becker's contributions are varied, often reaching outside the areas economists usually explore. He has developed theories of discrimination, marriage, divorce, fertility, and altruism, to name a few. For his efforts Becker was rewarded with the Nobel Prize in economics in 1992.

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In the area of human capital, Becker developed a theoretical model for deciding whether to invest in, for example, a college education. In the model, the direct costs (tuition, books) and indirect costs (forgone income) are measured against the benefits (the additional earnings resulting from a college education). As with most decisions in economics, if the benefits exceed the costs, the investment should occur. Becker also distinguished between general and specific training. General training creates skills and knowledge that are portable; that is, they enhance productivity wherever the worker might go. Specific training only improves productivity within the firm in which it is given.

On the importance of human capital theory, Becker wrote these prophetic words at the end of Human Capital: "I would venture the judgement that human capital is going to be an important part of the thinking about development, income distribution, labor turnover, and many other problems for a long time to come."


  1. Theodore W. Schultz, "Investment in Human Capital," American Economic Review 51 (March 1961): p. 3

Photograph courtesy of: (c)Ryan McVay/Photodisc # AA014251;


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Although not referring to it as such Smith offered one of the first articulations of what is now known as the principal-agent problem. For Smith, the principals are the owners of the corporation (what Smith referred to as joint-stock companies). The agents are the managers, hired by the ownership but not owners themselves. Smith believed that since managers were not motivated by profit, they would be negligent in their tasks and tend to spend excessively.

Adam Smith (1723-1790) is perhaps the most famous of all economists. At the very least he is the best-known classical economist and his contributions have played a significant role in shaping modern economic thought.

Born in Kirkcaldy, Scotland, Smith attended Glasgow College at age 14, and later studied moral and political science and languages at Balliol College, Oxford. After serving as a lecturer on rhetoric and literature in Edinburgh, Glasgow College, in 1751, elected Smith to be professor of logic and, a year later, the chair of moral philosophy.

Smith left Glasgow College 12 years later to serve as a private tutor. In the course of his travels as a tutor, Smith spent time in France, where he befriended Francois Quesnay and Anne Turgot. The two physiocrate economists helped shape Smith's thinking, as evidenced by his use of the French term, laissez-faire.

Before focusing his attention on political economy (the old term for economics), Smith published The Theory of Moral Sentiments in 1759. This work concentrated primarily on philosophy and ethics, and in particular the moral forces which guide behavior. Smith's best known work, the work that clearly defines Smith as an economist, was An Inquiry into the Nature and Causes of the Wealth of Nations (often referred to simply as Wealth of Nations), published in 1776. The 900 pages of Wealth of Nations contain not only the articulation of many time-tested concepts in economics, but also a refutation of the economic philosophy known as mercantilism. Mercantilists believed that nations should enact trade barriers with other countries so as to reduce imports and achieve a trade surplus. Their belief was that the wealth of a nation was in the gold and silver (bullion) it possessed, and that trade surpluses were a primary means to accumulating bullion. Smith argued that the wealth of a nation was the real goods it produced, not the money it possessed.

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Photograph courtesy of: (c)Nance Trueworthy


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The notion that higher wages promote greater productivity - efficiency wages - appears often in the history of economic thought. Although not credited with developing the term, Adam Smith (1723-1790) was one of the first to articulate the idea. Robert Owen (1771-1858), owner of the New Lanark spinning mills in Scotland, attempted to put the idea into practice. Owen, who owned and ran the mills from 1800-1820, also established the model community of New Lanark. Operating during the industrial revolution, a period in which wages were pushed to subsistence, Owen paid his workers significantly more than the prevailing wages of the time, and his mills were both productive and profitable.

Several economists developed formal theories of efficiency wages. These theories are summarized by George Akerlof and Janet Yellen, eds., in their book, Efficiency Wage Models of the Labor Market (Cambridge: Cambridge University Press, 1986).

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