Organization Salary Determinations

Inflation

Salary increases that fully reflect cost-of-living increases also create inflation in the economy. This is because the increases are not offset by improvements in productivity. Therefore, employers compensate for these pay raises by raising prices of the products or services.

Although escalator clauses narrow the time gap between price and salary changes in an inflationary period, they've been found to cover only about half of a year's inflation. Typically, escalator clauses are only used in public-sector employment contracts.

Labor contracts containing re-openers, deferred increases or escalators are prevalent in the United States. Most pay decisions are widely decentralized and the heavy weight given to comparable salaries may provide enough lag between price and salary changes to prevent more inflationary effects.

Deflation

Tying salary changes directly to inflation rates also means that when cost of living is decreasing, there will be a corresponding decrease in salaries. This actually occurred to the Colorado minimum wage on 1 January 2010. In 2006, Colorado voters pegged minimum salary rates to cost of living. A decrease in cost of living during 2008/2009 required that the minimum wage be lowered, however employers were encouraged not to lower actual wages.

In summary

The cost of living as a salary-level determinant usually has an indirect relationship. According to a study on this topic, nominal wages can be expected to increase less than proportionately with respect to measured cost of living and at a decreasing rate.

In periods of rapidly rising prices, the cost of living should never be used as the sole standard of salary adjustment, although this may be attractive to employees, unions and some employers.

When influences in the labor market are stronger than those in the product market, cost-of-living considerations may increase an employer's willingness to pay. However, when an employer is faced with strong competition in the product market, employees may have to choose between maintaining their real salaries and maintaining their jobs.

In inflationary periods, the cost of living reinforces going salaries through employer willingness to pay.