Adam Smith on Differential Returns to Labor

wages labor markets how are wages determined labor and wages labor regulations

Maryann Keating for AdamSmithWorks

"The distribution of national income between wages and profit varies between time and place. However, variations in the return to labor across industries persist in nations both rich and poor and in economies that are advancing, stationary, or declining. Smith maintains, the proportion between wages in different industries remains the same, and cannot be altered, at least for any considerable time."

November 15, 2023

Equal opportunity is of greater concern than equality of outcomes. Nevertheless, economists study wage inequality intensely. Actually, Adam Smith admits that his chapter on wage differentials is overly long. His chapter consists of two parts. Part I deals with natural and therefore inevitable wage inequalities and Part II, with policy-driven attempts affecting the return to labor (Wealth of Nations, Book I, Chapter X, “Of Wages and Profit in the different Employments of Labour and Stock”).

Smith does not concentrate on wage disparities deemed to be “too big.” He provides examples of households’ combined income due to full and part-time labor plus ownership of capital. Recent U.S. 21st Century experience is more in line with Smith as compared with a mid-20th household living on income from a single wage earner, with little or no financial assets or government transfers. However, Chapter X focuses specifically on wage differentials because Smith thinks that the average return to “stock” [capital assets] is more uniform across industries.

The lesser mobility of labor, according to Smith, does not preclude an efficient labor market.

If in the same neighborhood [all other things being equal], there was any employment evidently either more or less advantageous than the rest, so many people would crowd into it in the one case, and so many would desert it in the other, that its advantages would soon return to the level of other employments. This at least would be the case in a society where things were left to follow their natural course, where there was perfect liberty (Part I, 1).

Smith refers to a “natural wage” for any given skill and effort level; we might think of it as an equilibrium wage “all other things being equal.” In typical Smith fashion, he neither ignores personal physical and intellectual abilities nor emphasizes them unless relevant. He trusts markets to naturally discern talent and excellence.

More recent economic texts refer to the demand for labor as a “derived demand” recognizing marginal productivity in combination with capital; this departs from a labor theory of value. Similarly, Smith does not write that a person should be guaranteed a wage reflecting their position in society or personal talents. Rather, free persons must first enter the labor market of his or her choice and accept or reject the salary offered. Furthermore, Smith emphasizes that the size of the market and location affect cost one’s return to labor and capital.

Therefore, Smith’s chapter may be viewed as one advising young persons and their benefactors on the realities of career choice.

First, the wages of labor vary with the ease or hardship, the cleanliness or dirtiness, and the honourableness or dis-honourableness of the employment (Part I, 2).

It is obvious to most that someone collecting trash in harsh weather will earn more than one selling shoes at the mall. Generally, less accepted is the fact that those in, for example, the arts earn but a “scanty subsistence.” Smith attributes this to the fact that in an advanced economy, the number of people who pursue these activities for pleasure makes more people “follow them than can live comfortably by them.” It is difficult to earn a living doing something that many consider a hobby or not their “sole principal employment.” Note, however, that Smith has no objection to those willing to substitute satisfaction for reduced compensation.

Smith offers an example of the premium earned by catering to a difficult clientele. There is “scarce any common trade in which a small stock yields so great a profit” as that of proprietors willing to expose their capital, labor, and property in operating hotels and bars.

Secondly, the wages of labor vary with the easiness and cheapness, or the difficulty and expense of learning the business (Part I, 5).

Wage differences between skilled and ordinary workers vary with educational expenses and the practice needed to acquire dexterity. This financial return, according to Smith, must be received “in a reasonable time, regard being had to the very uncertain duration of human life.” He observed that mechanics, carpenters, and manufacturers earn a slight wage premium over those who learn their trade remotely on the family farm or in producing homemade items. Nevertheless, Smith maintains that the steadiness and superior earnings of journeymen in service are “no greater than what is sufficient to compensate the superior expense of their education.”

Consider a current situation in which university graduate students in economics and the liberal arts generally are awarded a stipend plus tuition. As such, their lifetime compensation is likely to be less than other students entering riskier professions that require going into debt or paying out-of-pocket expenses. Smith notes, “The pecuniary recompense, therefore, of painters and sculptors, of lawyers and physicians, ought to be much more liberal [generous]: and it is so accordingly.”

Thirdly, The wages of labor in different occupations vary with the constancy or inconstancy of employment (Part I, 11).

Smith observed that the day wages of low-skilled masons and bricklayers in London were somewhat higher than those of house carpenters. In seasonal work, Smith explains, what is earned “must not only maintain him while he is idle, but make him some compensation for those anxious and desponding moments which the thought of so precarious situation must sometimes occasion” Today, we observe higher annual salaries earned in careers peeking at an early age with limited duration.

Fourthly, The wages of labor vary according to the smaller or greater trust that must be reposed in the workmen (Part I, 17).

Smith indicates that irrespective of the industry in which they are employed, prudent and honest traders may be rewarded with a personal premium. However, he attributes the persistent higher earnings of most physicians and attorneys, educational expenses aside, to the perceived value in entrusting to them one’s health, fortune, and reputation.

Trust is an issue in certain other occupations. Smith notes that those entrusted with large amounts of someone else’s capital or precious assets, like jewelers, earn a premium in addition to that awarded for their skills.

Fifthly, the wages of labor in different employments vary according to the probability or improbability of success in them (Part I, 21).
(NOTE: in some cases in listing the five characteristics, the “t” in “the” is capitalized and in others “t” is not. In quoting Smith, I prefer to keep his notation and spelling)

Occupational choice is influenced by the probability of financial success. Smith refers to lotteries in analyzing this decision. An ordinary return is relatively certain in some fields. However, he says that if a parent pays for a child “to study law, it is least twenty to one if ever he [or she] makes such proficiency as will enable him [or her] to live by the business”.

Smith poses a provocative question. Does the compensation received by a tedious and expensive legal education of one successful student equal the total loss for the “more than twenty others who are never likely to make anything by it?” Probably not, he answers, because financial returns in law “as well as [in] many other liberal and honorable professions are, in point of pecuniary gain, evidently under-recompensed.”

Why then do reasonable persons crowd into fields such as medicine, law, poetry, and philosophy? Smith hypothesizes that considerable part of the reward must be the satisfaction of being associated in some way with “what is called genius or superior talent.” Ultimately, he notes, we enter into risky occupational lotteries, where the average return far exceeds the median, because each of us tends to be over-confident in our personal abilities and good fortune!

Consider the greater total amount bet in gambling in a given year as compared with that spent on private insurance. In the choice of careers, young people are particularly attracted to the dangers associated with a life of adventures. Smith observed the large number of young men of dexterity and skill joining the navy. The navy at that time offered a small probability of earning a fortune along with the risk of great hardship and danger. Smith argues that a sailor’s pay “may not perhaps always exceed the difference between his pay and that of the common laborer,” because his free lodgings at sea cannot be shared by family.

A better explanation for the current “exorbitant rewards” earned by athletes and stage performers is required than the one given by Smith. He suggests that while the public generally agrees that their talents are agreeable and beautiful they are “by no means so rare as is imagined.” Their high wages, according to Smith, are in part a reward for the “discredit” of the public for their willingness to employ their talents in this manner. Certainly, there is an opportunity cost in becoming a public figure. However, we now tend to justify performers’ prestige and premiums to markets identifying superior talent and audience preferences. It is too early to predict how signing “Name, Image, and Likeness” contracts for certain students will ultimately affect their prestige, educational expenses, and future compensation.

Labor markets are dynamic and result in the displacement of workers and wage disparities for similar skills. Smith admits to being somewhat puzzled by the consistently higher wages earned in newer industries, considering the lower variability in established industries producing necessities. He hypothesizes that speculation in newer products and a futures market in agriculture result in “accidental variation in demand” could be responsible along with “fashion and fancy.” Presently, changes in worker demand due to production augmented by artificial intelligence may be considered accidental, but government intervention in the electric vehicle race is not. In both cases, the 2023 United Auto Workers (UAW) and the Writers Guild of America (WGA) work stoppages, attempting to boost wages and increase worker protections, could hasten worker displacement.

In Part II, Smith turns his attention away from natural factors affecting wages towards “…the policies of Europe, by not leaving things at perfect liberty, occasions other inequalities of much greater importance.” If Smith exhibits any bias in this chapter it is that poorly thought-out labor policies impose costs on the less influential. Three tools are used by policymakers' intent on interfering in labor markets.

First, by restraining the competition in some employments to a smaller number than would otherwise be disposed to enter into them; secondly, by increasing it [the number of workers entering into a particular industry] beyond what it naturally would be; and, thirdly, by obstructing the free circulation of labor and stock, both from employment to employment and from place to place (Part II, 2).

We consider first the potential of policy to restrain labor entry into a particular industry. Assume that certain traders and organizations of workers hope to limit the supply of their goods and services coming to market thereby raising price, profits, and wages. Smith argues, “The exclusive privileges of corporations [crony capitalists] are the principal means it makes use of for this purpose (Book II, 4).” He describes towns in the past in which governments were altogether in the hands of traders and artificers who created legal monopolies which Smith refers to as “corporations”. The interest of such trusts or syndicates is to prevent markets from being overstocked. Each group is eager to have government enforce their preferred regulations. Admittedly if several traders in a geographical area are successful in doing this, they must accept paying higher prices to other locals also attempting to do the same in limiting output. However, these policy induced higher-than-average returns to capital and labor hold whenever they trade with outsiders in the countryside and from distant regions.

Smith argues that the public loses when the number of entrants into any particular line of work is limited. Undoubtedly, If an industry can effectively raise the prerequisites for labor entry, the returns to present workers and their instructors will be higher than average. Smith uses traditional apprenticeships to demonstrate the point. Relating this to our times, suppose that the accounting profession, for example, could increase the number of credit hours required for entry and gain government support that all public accountants be certified. This would result in upward pressure on the wages for both accountants and their instructors.

Regulating the number of apprentices permitted by each firm and specifying years of service restrain competition. In Europe when Smith wrote, seven years seemed to be the established apprenticeship term. Smith includes universities as one of the original and primary organizations requiring students to study under a master for seven years. He argues that such regulations hinder an apprentice’s return on his or her skills and are a manifest encroachment upon just liberty.

Smith poses several more objections to mandated apprenticeship regulations. Long apprenticeships do not protect the public and, he thought, actually create in young persons an aversion to work. Those who experience sooner rather than later career satisfaction and wages are more likely to conceive a relish for working. Smith writes that for most trades, specialized knowledge and insights can be transmitted in a few weeks whereas judgment and discretion are acquired only through practice. Mandated apprenticeships benefit masters and effectively increase the expense of education.

In the recent past, U. S.occupational licensing has increased. In 1950, 90 occupations were regulated under 1,670 state laws. By 2022, the number of regulated occupations grew to 220 consisting of 4,836 laws (Julia R. Cartwright, “False Directions,” Law and Liberty, September 7, 2023). Do government mandates, as compared with the adoption of voluntary standards, ensure quality and protect the consumer? Smith writes:

As it [a regulation on entrance] hinders the one from working at what he thinks proper, so it hinders the “others” from employing whom they think proper. To judge whether he [or she] is fit to be employed, may surely be trusted to the discretion of the employers whose interest it so much concerns. The affected anxiety of the law-giver lest they should employ an improper person, is evidently as impertinent as it is oppressive (Part II, 12).

Smith points out that competition decreases wage premiums for easily acquired skills and compensation associated with individuals and firms associated with certifying attainment. Any current trend away from college degree requirements will put pressure on universities to offer training at competitive rates. In the United States in 1971, a Supreme Decision (Griggs v Duke Power) prohibited tests with a disparate impact used to screen potential employees. An unintended consequence is the ubiquity of a degree requirement, an artificial requirement leading to a wage disparity between those with and without a college degree (Graham Hillard, “Is Disparate-Impact Theory Constitutional?” The Wall Street Journal, August 24, 2023).

Smith also considers how policies unnaturally increase the number of workers in a particular industry. One tool available is to subsidize entry. Smith writes,

It has been considered as of so much importance that a proper number of young people should be educated for certain professions, that, sometimes the publick, and sometimes the piety of private founders have established many pensions, scholarships, exhibitions, bursaries, etc. for this purpose, which draw manly more people into those trades than could otherwise pretend to follow them (Part II, 34).

Smith maintains that large groups majoring in the liberal arts at public expense earn very paltry salaries. He viewed these fields as crowded with indigent people educated at public expense; this was the case even when schools differentiate between students and recognize talent. Before the advent of the printing press, scholars, according to Smith, were undistinguishable from beggars. The only employment available was in teaching or in communicating acquired curious and useful knowledge to private groups. On the other hand, in ancient times, before publicly subsidized education, the rewards to eminent teachers may have been considerable. The lifestyles of Plato and Aristotle suggest an above-average degree of affluence.

Smith concedes that the public on net gains important benefits from the output of the large number of available scholars, trained at public expense, who accept less-than-average income given their skills. However, he laments that these benefits would be higher if schools and colleges were more “reasonable.”

Finally, how does government policy act to affect labor entry and exit between industries and from place to place? Smith does not address the effects of government redirecting the amount of credit available to preferred industries and away from disfavored ones. Also, he does not discuss immigration or emigration policies and their effects on local wages. He does suggest that it is often more difficult for a poor person to pass through artificial local restrictions in seeking higher wages than national boundaries (Part II, 58).

Smith confines himself to policies affecting residents within a particular nation-state. However, job displacement is a concern, and economists differ on the advisability of using tariffs and restricted immigration to maintain resident workers’ standard of living. Most, however, admit that job displacement is a concern. One study indicates that losses due to displacement from higher paying jobs are minimized in those countries, such as Denmark and Sweden, in which the welfare payments are most generous (Bertheau Et Al, “The Unequal Consequences of Job Loss,” AER Insights 2023, 5(3), 393-408). This suggests that government might play a role in aspiring to a degree of wage equality across domestic industries. Writing in 1776, Smith believed that after 400 years it was time to lay aside all endeavors to bring under strict regulation, of what nature seems incapable. He adds by quoting Doctor Burn, “…if all persons in the same kind of work were to receive equal wages, there would be no emulation, and no room left for industry or ingenuity. (Part II, 60).”

Consider that in some countries with large rural populations, workers need permits to relocate into urban areas. Residency requirements are no longer a mute issue even in the United States. Days-in-state requirements to avoid higher income taxes affect labor mobility, particularly for those working remotely. Smith's extensive treatment of British poor laws gives credence to the old joke that welfare is covered in some states by issuing a bus ticket to another! While Smith does not specifically refer to mandates requiring local officials and police officers to live within a designated district, he does discuss clandestine residency.

Smith argues that employers rather than employees are more effective in getting the government to enforce their preferred policies regarding labor mobility. Physicians and lawyers forced to sign non-compete clauses would agree with him.

Smith writes, “I shall conclude this long chapter with observing, that though anciently [in the past] it was usual to rate [regulate] wages over the whole kingdom…these practices have now gone entirely into disuse (Part II, 60). Smith, nevertheless, observes how employers collude and lobby for wage ceilings, which they themselves, when convenient, violate by paying in kind rather than cash. He does not address organized labor or government mandated wage floors. However, he writes, “The complaint of the workmen that it [wage regulation] puts the ablest and most industrious upon the same footing with an ordinary workman, seems well founded (Part II, 61).

The distribution of national income between wages and profit varies between time and place. However, variations in the return to labor across industries persist in nations both rich and poor and in economies that are advancing, stationary, or declining. Smith maintains, the proportion between wages in different industries remains the same, and cannot be altered, at least for any considerable time.