21 August 2019

Why raising wages can save businesses money

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A slight weirdness about the world is that it is, often enough, cheaper to raise workers’ wages than reduce them. This is not the output of some righteous woke model where being deferential to employees pays dividends, this is a matter of cold hard cash. It’s also the solution to the current recruiting woes of the Armed Forces. For we’re told that they haven’t got a problem in gaining new troops and matelots – they’ve a problem retaining those they’ve already expensively trained and matured.

The answer is to do what Henry Ford did when he raised wages to $5 a day. Sadly, this is one of those mythical episodes heavily obscured by gross misunderstandings. It is commonly stated that he did this doubling of wages in order to create a market for his own cars. This is a surmise of glowing idiocy – it’s not possible for a producer to pull themselves up by their bootstraps in this manner. Think about it – say the wage bill rises by $100; that $100 is spent entirely upon Model Ts (in the form of the the wages of the people who make them). But only some part of the cost of making a new car is wages – so Ford will be out by the amount he’s got to spend on steel, rubber and so on to make that car.

You can’t increase profits by raising wages and getting your employees to buy your own product. Of course, if everyone else raises their wages then you can do very well but that’s a rather different issue.

The actual reason Ford raised wages was that he had a labour turnover of 370% a year. At one point in order to have 14,000 people on the assembly line he had to chew through 51,000 workers in a year. That’s an awful lot of recruitment and training expenses right there. So Ford’s answer was to raise the wages of the current workforce so they stayed –and the new wage bill was less than the old training one.

This concept is called “efficiency wages”, and it encompasses how economists generally think that wages are set. Rather than an all-out race to the bottom, hiring the cheapest it is possible to get, wages are usually determined by asking what an efficient rate of pay would be given a large range of factors. Maybe we’d prefer people to not be taking evening jobs to add to their income so that they’re actually awake when they’re at their desk for us? Maybe decent wages will create a sense of belonging, even good will, so that, say, losses from backroom stock being stolen fall. That last factor is one of the reasons why bankers are so well paid: they handle a lot of money, it’s easy enough to steal bits of it, high wages make people less willing to risk losing that job by doing that stealing.

It’s also necessary to recall that wages aren’t all that we gain from going to work. Total compensation is what matters – and that includes the conditions of work, the place, the hours, the pension. This is where the Armed Forces are having their retention problem. People are less willing to keep moving house, as working for the Armed Forces often dictates, while partners tend to work these days, making the inhospitable hours an increasing challenge.

But in such challenges lie the solution: raise the total compensation – not necessarily the wages – and thus retain the trained personnel that we’ve just spent however many hundreds of thousands in getting to the stage where they’re useful. This is exactly what Ford did, and why shouldn’t public sector employment take lessons from business? It can be cheaper to pay more in compensation if there’s a greater than corresponding decline in the training and recruitment bill.

Or as economists have been saying most of this last century, it’s not low wages we’re after, it’s efficient ones. But then trying to get the politicians to listen to the economists has always been a difficult task…

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Tim Worstall works for the Continental Telegraph and the Adam Smith Institute