Does The Public Sector Understand Wages?

This was first published on the Adam Smith Institute:

UK workers have been going on strike. But how do the teachers, nurses, and other public sector workers on strike know how much they should be paid? I can help steer them in the right direction with reference to the price system. Let me explain.

Think about your own job - how do you know if you're underpaid, overpaid, or paid just about right? If you're in the private sector, there's a good chance that your pay is just about right, because there is nothing more efficient than the price system for determining the right levels of pay.

I'll oversimplify the following example slightly for the purposes of illustration. Suppose we have Jack, who is overpaid in his job, and Fred, who is paid about right. Imagine the country has lots of job vacancies at the right labour rates. If Jack's wages are cut to the marginal rate, then he'll be unhappy because he's no longer overpaid. If Fred's wages are cut, then he'll now be underpaid, and he can move to a job in which he will be paid his marginal rate.

Cutting Jack's pay was a good move for his employer, but cutting Fred's pay was a bad move for his. Why? Because Fred's employer has been outbid by a more competitive employer paying the marginal rate. Fred's ability to find another job at the rate he was on is pretty much all the evidence you need that he was not overpaid. But Jack's grievance at his pay cut stems largely from the fact that he'd find it difficult to get another job at the same rate, which is pretty much all the evidence you need that he was overpaid.

Remember, in economics, the price system for labour in terms of the employee also has a logical standard - the worker ought to be paid the amount that makes their job more desirable than the next best alternative. That's why there is competition for employers to pay rates that will attract the best employees.

I don't know what the exact rates of pay should be for doctors, nurses, paramedics or teachers, but I can tell what we should want to see if we want those industries to thrive. We want to see the wages set to enable the vacancies filled, and to the level that public sector workers are invested in their careers, and satisfied in their work, but not so satisfied that they are earning over their marginal rate. In economic terms, we want them to prefer their job to the next best alternative, and we want their pay to reflect those preferences in accordance with the price system.

The situation should reflect the following: given a pool of identical employees, some of whom are producing X a month in the private sector, and others who are producing X + Y a month in the public sector (and vice-versa), you'd want to move the marginal worker to the sector closest to X (where X is the correct marginal rate) - and this should extend in both sectors in all industries until the two productivities reach equilibrium. At which point, we have an efficient allocation, whereby the output of the doctors, nurses, paramedics or teachers would be the same as it would be in a private sector job.

There's another reason why it's important for public sector employers to pay their employees something approximating the market rates, and not underpay or overpay them. We want a society in which everyone is incentivised to contribute most, in accordance with their talents and skills - and, again, there is nothing as efficient as the price system for determining who is doing what. Every highly skilled and talented individual who is hired in one sector is no longer available in the other.

If workers are overpaid in one sector at the expense of the other sector, then labour rates are not optimally set in a way that draws the right employees into the right jobs and careers. We don't want the brightest neurosurgeons incentivised to work in IT, we don't want the brightest data scientists in public sector middle management jobs, and we don't want our top physicists tempted to work in the retail industry. For that reason alone, as much as we don't want our public sector workers to be underpaid, we don't want them to be overpaid either.

As we've said, the best way to determine the right level of pay is the price system; and the best way to determine if the public sector pay levels are right is to ensure that they as closely matched to the equivalent roles in the private sector as possible. The trouble is, in most cases, it is difficult to know which jobs in the private sector are comparable or equivalent to jobs in the public sector - there are too many factors to make an easy comparison, which makes the desires and the negotiations somewhat intractable.