Does a Tightening Labor Supply Drive Up Wages?

Does a Tightening Labor Supply Drive Up Wages?

by Damon Runberg

April 28, 2016

Here is the basic theory on wage growth. When there is a high demand for labor (businesses hiring) and the supply of labor shrinks (individuals get hired) then businesses are compelled to offer higher wages to attract the diminishing supply of good workers in the labor force. The logic is sound, but what happens in practice? Let's take a look at three different economies, Deschutes County, Klamath County, and Oregon; each posted varying rates of job growth over the past several years. Are wage gains associated with the tightest labor markets?

Deschutes County is one of the fastest growing metropolitan statistical areas in the United States both for population growth and job growth. As of January, the county posted the fifth fastest job growth of 388 metro areas nationwide. The labor supply is tightening despite the fast population growth. Although the county is growing rapidly, a large share of the population growth is coming from retirees who are not contributing to the labor supply. The pool of available labor is shrinking in Deschutes County, which can be seen by the declining unemployment rate (4.8% as of March 2016).

Klamath County is in a different situation. There are signs that hiring may pick up soon, however employment levels remain down over the past year. Unemployment levels are higher, job growth remains elusive, and population growth is relatively slow.

Finally, Oregon as a whole sits between Deschutes and Klamath counties. Despite slower levels of job growth and population growth, statewide the supply of available labor is actually slightly tighter than in Deschutes County with unemployment levels down to 4.5 percent. If the theory is correct, than we should see faster rates of wage growth in Deschutes County and statewide, where rapid job growth is drawing down the number of unemployed. Klamath should see slower rates of wage growth as the labor market is less competitive.

When looking at the data for the three areas combined we find there is a definitive relationship between average annual wage and the unemployment rate. The correlation is negative, meaning as unemployment declines we see wages go up. This relationship is what we would expect. Wages rise as the labor pool shrinks. It is apparent that the relationship isn't strictly linear. As unemployment levels reach lower and lower levels, the pace of wage growth accelerates. In fact, there is little change in wages until the unemployment rate drops below 8 percent.

When isolating the past nine years there is approximately a $262 rise in average annual wage for every percent drop in the unemployment rate. However, as mentioned above, this relationship isn't strictly linear. Between 2010 and 2011 the unemployment rate in Oregon dropped by about 1 percent. During that period the average annual wage only rose by about $144. Over the past year, unemployment levels also dropped by around 1 percent, however, we saw statewide wages rise by a whopping $1,800. Why the difference? The rate was 9.5 percent in 2011, while the rate was 5.7 percent in 2015. It seems that the pace of wage growth accelerates as the unemployment rate reaches lower levels. In fact, the rate of growth was fairly modest until Oregon's unemployment rate dipped below 8 percent.

Both Deschutes and Klamath counties saw much slower rates of wage growth over the past nine years. For every 1 percent drop in the unemployment rate, Deschutes County wages rose by around $170, while Klamath saw theirs rise by around $150 for every 1 percent improvement to unemployment levels. Why are wage gains more modest in Deschutes and Klamath counties compared with the state as a whole? They posted higher rates of unemployment, so it has taken longer for area businesses to feel compelled to offer higher wages due to a tightening labor supply. As access to smart, reliable, and experienced workers shrinks, businesses in Central and South Central Oregon are offering higher wages as a recruiting tool. Unemployment rates below 8 percent yield much faster wage growth; however, when the rate is above 8 percent, wage gains are quite modest. Area unemployment rates only recently dropped below 8 percent (2014 for Deschutes and 2015 for Klamath). Today, Deschutes County is approaching levels of unemployment comparable with the state. The tightening labor supply helped to drive up the average annual wage by nearly 4.5 percent over the past year.

There are other factors that affect wages. For instance, the types of jobs being added have a large impact on local wage gains. Are we adding high-paying tech jobs or lower paying retail jobs? The former will show accelerated wage gains, while the latter would reveal more modest growth in wages. Regardless, there is a very strong relationship between the pool of available labor and wages. As we see unemployment rates drive below 8 percent in most communities across Central and South Central Oregon, we can expect to see an acceleration of wage gains.