Wages, Earnings and Labour Costs

Wages and earnings received by employees can be expressed in a number of ways:

  1. As a nominal amount, i.e. an amount expressed in units of the local currency such £s;
  2. As a real amount, i.e. an amount of goods and services that the nominal wages or earnings would purchase. This is equal to the nominal wages or earnings divided by the price of a typical bundle of goods and services;
  3. As an amount of an arbitrarily selected country’s (usually the USA) goods and services that the nominal wage or earnings would purchase. This involves converting the nominal variable in one currency into another and hence an exchange rate. The exchange rate can be the rate in a particular year or, since these rates are volatile, purchasing power parity exchange rates, i.e. the exchange rate that would imply that a given bundle of goods and services could be bought for the same amount of any given currency in either country.

Economy-wide series on nominal wages and earnings are derived by weighting the nominal wages or earnings of individual groups of workers by the importance of that group of workers in the overall workforce. Nominal wage or earnings inflation is the percentage rate of change of the resulting series.

To obtain series on real wages a series on the price of a typical bundle of goods and services is required. The usual measure is the Consumer Price Index which is a weighted average of the prices of the goods and services that consumers buy. The weight attached to any item is determined by how much of that item a “typical” consumer buys: the greater the volume of an item the consumer buys the greater the weight it receives in the index.

The rate of change of the constructed real wage or earnings series over the previous year is then the annual rate of change of the average real wage or earnings.

Labour costs – the costs to businesses of employing labour – are made up of wages and salaries plus non-wage costs such as employers’ social contributions. Unit labour costs are these costs measured per unit of output produced. Since labour costs are generally a major part of the total costs of producing goods and services they play a major role in the prices of goods and services. To illustrate this link – and to show the importance of labour productivity in that link – here is a very simple example.

Imagine that labour is the only factor used to produce output and that the amount of output produced, Q, equals the amount of labour employed, N, times a number A which represents labour productivity: the higher is A, the more productive a unit of labour is.

[1] Q = A×N

Let W stand for the nominal wage per unit of labour and be the only cost of labour. Then a firm’s total costs, TC, will be

[2] TC = W×N

Its costs per unit of output will therefore be TC/ Q which from [1] and [2] is given by

[3] TC/Q = (W×N)/(A×N) = W/A

The price of a firm’s goods is likely to be related to the average costs of producing the good. As W rises, given A, the price of the good will rise; and as A rises, given W, the price will fall.

Labour costs in this example are given by W. Unit labour costs by W/Q or W/(A×N).

For a country with a given level of employment, a rise in its unit labour costs means a rise in W/A and hence a rise in the price of its goods. Relative unit labour costs are therefore one way in which a country’s competitiveness is assessed. If other countries are experiencing smaller rises in their unit labour costs then the country is becoming less competitive. This will be especially true of countries operating fixed exchange rates or those in a common currency area such as the Euro zone: they cannot offset the effect of a rise in their relative unit labour costs by devaluing their currency.

Commentary - Wages, Earnings and Labour Costs

The commentary focusses mainly on wages and earnings growth in the UK, highlighting the unprecedented decline in real wages over the last 5 years. It also compares movements in labour costs in the UK and some Euro-area countries.

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