Why are wages less stable in skilled professions?

There is some evidence, in fact, that markets for highly skilled workers, such as engineers and other specialized professionals, exhibit systematic periods of boom and bust…1

Earnings tend to fluctuate significantly more in highly skilled professions than in others, rising to high levels for a number of years before plunging and, ultimately, rising again. Why is this the case? Here’s the explanation put forward by Harvard economist George Borjas in his leading textbook on Labor Economics.2

What’s going on?

In most professions which are low-skilled or have low barriers to entry, wages stay relatively constant over time. This is because as the number of jobs increases, people are easily able to move into that profession to take those jobs and only minor wage increases will be needed to tempt them across. Similarly, if the number of jobs decreases, workers will move away into other professions with better prospects. In this way, the supply of labor easily follows demand, and wages in the profession stay reasonably constant.

However, the situation is rather different when it comes to some highly skilled professions. To see why, let’s take it step by step.

  1. Say there is a sudden demand for more engineering graduates.
  2. People cannot just move straight across from other professions to fill the new roles as they don’t have the qualifications. As a result, the demand for engineers remains higher than the supply, and wages go up as companies compete to hire from the limited pool of engineers.
  3. Seeing the increased wages on offer, more people enroll on engineering degree courses in order to take those jobs at the end and earn those wages.
  4. However, when they come to the end of their courses, there may well be many more new graduates than the number of jobs available – especially as year after bloated year of eager engineering graduates spill into the labor market.
  5. Now the supply of engineers is higher than the demand. As a result, employers can offer lower wages (perhaps even lower than they originally were) and still be sure that there will be enough engineers to fill their jobs.
  6. At this point, with the rewards so low, people will become much more reluctant to enroll on new engineering degree courses.
  7. In the short term, this will help to equalize supply and demand as the “excess” engineers from the earlier rush will be able to find jobs. But as the years go by with few new engineers entering the market, the supply is likely to fall below the demand again.
  8. Return to the beginning, and repeat.

This explanation for fluctuating wages is called the cobweb model (named after the shape of the supply-demand diagram it creates).

Why does it work like this?

The cobweb model makes two key assumptions. The first is reasonable: it does take time to produce new engineers, so the supply of engineers can be thought of as perfectly inelastic in the short run.3

The example above illustrates that where a job requires specialist training, the supply of labor is going to lag behind demand. When the demand goes up, wages will rise until enough people have gone through training to fill the new jobs. When demand goes down again, wages will also fall until the excess workers have found jobs (or left the profession).

But there’s another crucial factor that makes this all possible:

The second is more questionable…The cobwebs are generated, in effect, because students are misinformed. They do not fully take into account the history of wages in the engineering labor market when choosing a career.4

For this effect to take place, prospective engineers must primarily base their career decisions on the wages engineering graduates earn right now. If instead they looked at the trends, they could work out what is most likely to happen at the point at which they actually enter the profession and act with full information.

However…

The evidence provides strong support of cobwebs in many professional markets, so it seems as if students systematically misforecast future earnings opportunities.5

So how can you avoid this error? The best way is to look at historic wage data for the profession (adjusted for inflation) and take an average of earnings over time. That will give you a better sense of the income you’re likely to earn in that profession, and help you to make the most informed choice possible.

Notes and references

  1. Borjas, George J. “Labour Economics, International Edition” McGraw-Hill Education (2013), page 185.
  2. Borjas, ibid., chapter 4-8.
  3. Borjas, ibid., page 187.
  4. Borjas, ibid., page 187.
  5. Borjas, ibid., page 187.