Real Wage
The real wage is the wage measured in terms of the goods and services it can purchase, that is, the nominal wage deflated by a price index. It is the economically relevant measure of the return to labour, determining purchasing power and the incentive to supply labour.
Definition and Measurement
The real wage is computed by dividing the nominal wage by a price index, typically a consumer price index for workers or a producer price index for firms. The choice of deflator matters, since workers care about consumer prices while firms compare wages to the prices of their output.
Care must be taken in comparing real wages over time, because the composition of the workforce and of the goods consumed changes. Quality adjustment and changes in the basket of goods affect the measured real wage, and different indices may give different pictures of trends.
Real Wages and the Labour Market
In the classical model, the real wage adjusts to equate the supply of and demand for labour, clearing the market at full employment. A fall in labour demand lowers the real wage, and the labour market clears. In the Keynesian model, nominal wage rigidity and other frictions can prevent this adjustment, so that real wages and employment may deviate from their full-employment levels.
The relationship between real wages and employment is central to the analysis of the labour market. In the competitive model, movements along the labour demand curve relate employment to the real wage, while shifts in productivity and other factors shift the curve. In models with bargaining, real wages are determined by negotiations and by institutional factors as well as by market conditions.
Real Wages and Productivity
Over the long run, real wages tend to grow with productivity. Because labour becomes more productive, firms can pay more while maintaining profitability, and competition for workers transmits productivity gains to wages. The close long-run relationship between real wages and productivity is one of the most robust regularities in economics.
In the short run, real wages can diverge from productivity, reflecting changes in the terms of trade, in the distribution of income between labour and capital, and in the bargaining power of workers and firms. The divergence has implications for the labour share of income and for the distribution of the gains from growth.
Real versus Nominal Wages
Confusion between real and nominal wages is a common source of misunderstanding. A rise in the nominal wage does not imply a rise in the real wage if prices have risen by as much or more. Workers care about the real wage, since it determines what they can buy, though they may also care about the nominal wage for reasons of fairness and comparison.
The distinction is central to the analysis of inflation and of wage bargaining. In an inflationary environment, workers seek nominal wage increases to preserve real wages, and the outcome of bargaining depends on the extent to which inflation is anticipated and on the institutions that govern wage setting.
Real Wage Rigidity
Real wage rigidity refers to the failure of real wages to adjust to clear the labour market. It can arise from institutional features, such as minimum wages and collective bargaining, from implicit contracts that stabilise wages, and from efficiency wage considerations, in which firms pay above-market wages to motivate workers.
Real wage rigidity contributes to unemployment when the equilibrium real wage exceeds the market-clearing level. The unemployed are willing to work at the prevailing real wage but cannot find jobs, because the wage is above the level at which the labour market would clear. The analysis of real wage rigidity is central to the explanation of persistent unemployment.
Efficiency Wages
Efficiency wage theories hold that firms may pay wages above the market-clearing level to increase productivity, to reduce turnover, to attract better workers, or to discourage shirking. The resulting wages are higher and employment lower than under a competitive labour market, generating involuntary unemployment.
The theories explain why firms might not cut wages despite the presence of unemployed workers willing to work at lower pay. They provide a microfoundation for wage rigidity and for the existence of equilibrium unemployment, and they inform the analysis of labour market institutions and of the effects of policy.
Real Wages over the Business Cycle
The behaviour of real wages over the business cycle is a long-standing puzzle. In the competitive model, real wages should be procyclical, rising when labour demand is strong. In the data, real wages are only weakly procyclical, and in some periods they are acyclical or even countercyclical.
Explanations for the puzzle include the presence of implicit contracts, which stabilise wages, and the composition of the workforce, which changes over the cycle. The behaviour of real wages remains an area of empirical and theoretical research, and it informs the assessment of labour market models.
Real Wages and Inequality
The distribution of real wages across workers has become more unequal in many economies, reflecting changes in the returns to skill, in technology, and in institutions. The growth of wages at the top has outpaced that in the middle and at the bottom, contributing to rising income inequality.
The analysis of wage inequality combines the study of labour supply and demand with the analysis of institutions, including unions, minimum wages, and the structure of bargaining. The trends in real wages and their distribution inform the debate about the sources of inequality and the design of policies to address it.