Many pundits, especially highly intelligent liberal pundits, often fall into the trap (fatal conceit?) of assuming that because they can’t explain why the market would do something, the market must be wrong. But markets are almost infinitely subtle.
A commenter recently asked me the following:
Does the union worker generate twice the marginal value of a non-union worker? Have CEO’s become insanely more productive in the last 30 years? Do janitors for financial firms produce substantially more value than janitors at restaurants?
My answers are:
Yes, yes, and heck yes.
Let’s start with the union workers. Even if nonunion workers are equally skilled, a firm will have an incentive to hire workers up to the point where the marginal revenue product of one extra worker is just equal to their wage (or marginal cost, if the firm has monopsony power.) In that case a union firm will hire fewer workers than otherwise, and use more capital. Thus even if the workers have identical talent, the union worker will be more productive at the margin. This point often confuses Americans who wonder how we could possibly compete with Chinese workers who seem just as productive but earn only 1/5 as much. (And how do Chinese workers compete with Bengali workers?)
CEO pay has been controversial for two reasons. It has risen very rapidly in recent years, and it often seems unlinked to performance. But pay is very closely linked to expected performance, which matters when contracts are signed. A few months ago Steve Ballmer resigned as CEO of Microsoft and the stock rose by billions of dollars. More recently, Larry Ellison (sort of) stepped aside from Oracle, and the stock plunged by billions of dollars. This shows that CEOs have a huge impact of stock valuations. Whether the market is rational in believing that is a trickier question, but it’s the job of corporate boards to put people in place that will maximize shareholder value. That means they need to at least try to get the very best, even if it costs a lot of money in terms of higher salary. If they aren’t paying obscene salaries then the board of directors isn’t doing its job.
Back in the 1960s, corporate decisions were much easier. You allocated capital to new auto factories, steel mills, appliance makers, and churned out product for which you knew consumers were waiting. Even IBM was fairly predictable for a time. In contrast, a modern CEO at a high tech firm might find the company quickly destroyed by new technology if he doesn’t keep on his or her toes. Think how much Sony would have benefited in the past 10 years if it had had the Samsung management team. Perhaps an extra $100 billion in shareholder wealth? And that’s also why the finance sector is so much more important today, decisions over where to allocate capital are both more difficult and much more important.
[Another reason CEOs used to be paid less was the 90% marginal tax rates. And by the way, saying CEOs should get high salaries does not imply they should not face high MTRs, which is a very different issue.]
You might think that a secretary is a secretary and a janitor is a janitor. Not so, they vary quite a bit in competence. Goldman Sachs has much more to lose from an incompetent secretary than does a small accounting firm in Des Moines. Even the janitors at Goldman Sachs are more important. The executives there are very rich, and the visiting clients are very important. The cost of an overflowing toilet in the men’s or lady’s room is much greater (in dollar terms; lost consumption to employees or lost business to unimpressed clients) than at a McDonald’s rest room. Thus Goldman Sachs should pay more, to ensure they get the best secretaries and the best janitors.
READER COMMENTS
Rick Hull
Sep 29 2014 at 12:13am
On third point, Goldman Sachs also has much more to lose from a malicious janitor or secretary. I imagine there are extensive background checks and other vetting processes which increase hiring cost.
After hiring and giving access to sensitive areas and equipment, GS wants to maximize loyalty and minimize any chance of a disgruntled employee. The lowest skilled positions at wealthy, powerful firms are well paid relative to the national median specifically to minimize envy within the firm and provide cheap insurance against a security breach.
Kevin Erdmann
Sep 29 2014 at 1:17am
Yeah, the tendency to think in categories is a common problem. I’m always hearing people worrying about job mismatches & McJobs. QuickTrip is a convenience store chain that clearly has a business plan that includes highly capable store personnel. Its fun to go in when they are busy. Its like going to a cirque de solail show. How can one guy run two registers at once, at full speed, while telling someone where the milk is, without breaking a sweat? They are probably statistically categorized as cashiers, but the quality of worker, and I assume the job satisfaction and remuneration, at QuickTrip compared to other stores is not comparable. It’s impossible to fully anticipate market dynamism.
Kevin Erdmann
Sep 29 2014 at 1:21am
Then you hear, “well why can’t Wal-Mart use that business plan so everyone can make better wages?”
Joe Kristan
Sep 29 2014 at 8:40am
As an owner of a “small accounting firm in Des Moines,” I prefer to believe that we don’t have to pay as much as Goldman Sachs because our employees don’t have to work with people who work at Goldman Sachs.
Andrew_FL
Sep 29 2014 at 9:16am
In answering to the affirmative on the first point (but not the second or third) I believe you are in error assuming that because greater productivity begets higher wages, that higher wages must beget higher productivity.
If a worker is more productive-he adds more value at the margin-he will be paid more. But it does not follow that the reverse is true, that if you pay a worker more they will be more productive.
I flat out do not agree that membership in a labor cartel carries with it magical powers to make someone better at their job, or that the resulting monopoly prices are the result of greater productivity. I even more do not agree with the implied reverse causality: that by forcing employers to pay them more, members of a labor cartel increase their productivity.
Only if the labor cartel is faced with a constant threat of being broken could it be the case that their wages reflect their productivity, in which case the choice between a union employee and a non union employee would be a matter of indifference-the total compensation being the same either way. It’s not that union employees are more productive. Their wages relative to non union employees generally merely reflect their presence in more productive occupations to begin with.
On the other points however, I concur with your affirmative answers.
Scott Sumner
Sep 29 2014 at 9:32am
Rick and Kevin, Good points.
Joe, Yes, I deserved that rebuke.
I sometimes forget that my roots are in the Midwest.
Andrew, When you hire more workers it does “magically” make the MP of existing workers decline. The personal characteristics of the workers doesn’t change, but their MP does.
Of course in the long run competition from non-union firms drives unions of out existence, unless they are protected by some sort of barrier to entry.
Ken from Ohio
Sep 29 2014 at 9:53am
I don’t agree with Prof. Sumner’s discussion of labor union wages.
A labor union is a coercive relationship (not voluntary) and therefore it cannot be considered a market wage.
Certainly a company faced with an imposition of high union wages will do all it can to offset that cost, such as using capital investments (robots etc) to replace workers. And the capital investment may then make the workforce as a whole (fewer workers at higher individual wages) cost effective at the margin.
But again this is not a market process.
Hazel Meade
Sep 29 2014 at 10:56am
More importantly, the janitors at Goldman Sachs have access to all sorts of sensitive material that gets thrown in the trash. They need to be people you can trust to destroy confidential documents and not steal them and sell thing to competitors.
Pajser
Sep 29 2014 at 11:52am
Highly intelligent communist pundits typically understand why market distributes resources as it does, but they do not think that market distribution is “right” in the sense “the most moral” or “the most efficient” or “the least coercive.” But market really is very subtle and it is not very easy to design more efficient (unlike more moral and less coercive) society, I’ll give that with smile.
Bob Murphy
Sep 29 2014 at 1:27pm
Great post Scott!
Andrew_FL
Sep 29 2014 at 2:56pm
My real goal was to get you to say this explicitly.
I would note then that the continued existence of union firms in areas they have long been present, must imply barriers to entry are protecting those firms-or that the long run isn’t here yet. One of the two, or some combination.
But if there are barriers to entry, it would be helpful to identify them so that, if possible, they can be addressed. Especially if these barriers are legislative in nature.
Rick Hull
Sep 29 2014 at 4:35pm
Ken from Ohio,
Unions are not necessarily or inherently or definitionally coercive, though we do have many laws on various books in the USA which provide coercive privileges specific to unions. Unions do not necessarily exercise these legal privileges, and there may be jurisdictions which are relatively free of such laws.
That said, given the fact that most unions do exercise coercive power, much of your analysis stands. Nonetheless, I would argue that it is a market process which substitutes capital (machines, robots, etc) for labor in the face of non-market interference.
John Kurtus
Sep 30 2014 at 5:14am
Excellent article. One nit to pick however: the rapidly rising pay of CEOs.
I have found that most of the “reports” about this apparent inequality only compares the top 350 or so CEOs to all workers in the US. Considering there are over 400,000 CEOs and almost two million General and Operations Managers, 50% of whom make $250,000/year or less, maybe it’s time rethink this meme.
http://www.statisticbrain.com/ceo-statistics/
Scott Sumner
Sep 30 2014 at 11:33am
Ken, I agree with Rick’s reply.
Hazel, Good point.
Thanks Bob.
myb6
Sep 30 2014 at 5:56pm
I don’t think maxk is really asking about “marginal value given the artificial constraints under which we’re currently operating.” He’s probably actually thinking about “marginal value given a unconstrained market”, in which case he’s probably right to be suspicious.
The union-worker has double the marginal productivity precisely because he’s arranged an artificial constriction of similar labor. He’s still a massive rent-earner.
CEO pay: how can you believe in the Great Stagnation and then argue that there’s been such a boom in the value of market-nimbleness? How come the CEO pay problem is overwhelmingly limited to the Anglosphere?
CEO pay is probably just a social phenomenon: there’s too much that no one knows, it’s an illiquid market, and there’s not nearly enough N or time for evolutionary processes to take place before the information is out-of-date.
I agree it’s silly to claim that every economic outcome we don’t understand is a market failure or a utility-destroying constraint on the market. However, it’s equally silly to claim that such failures and constraints don’t exist and aren’t important when they’re staring us in the face.
Marcel W
Sep 30 2014 at 9:20pm
Professor Sumner,
I too have questions about the CEO pay angle.
First, if CEO have higher pay because of increased productivity, are Japanese and German CEO less productive than British or American CEOs? Can this effect be measured? Are Japanese or German companies less well run than American or British companies? Average American CEO pay doubled between 1990 and 1995 and then quadrupled from 1995 to 2000! Did CEO productivity really rise that quickly? Were CEOs in 2000 10x more effective than in 1990?
Secondly, I’m not sure that being a CEO in the 1960s was any easier. Most companies were not as specialized as they are today (the idea of core competency was not in vogue). Was the job of the CEO of say, a huge conglomerate like ITT or Ling-Temco-Vought, harder than one where a CEO only has to engage in one core competency?
maxk
Oct 1 2014 at 12:03am
Sorry, I’m not convinced at all. I think you are assuming things that just often aren’t true. Think of the classic example of a coal mine in the early part of the 20th century. In my head (or perhaps in my blind spot!) these are workers who were being paid substantially less than their marginal product – because the mine owners had a local monopoly, because there weren’t good alternatives, because the magical competition that should eliminate this circumstance wasn’t operating as in the textbooks.
Then the workers unionized over the very strong objections of the mine owners (Pinkerton guards, acts of sabotage, deaths, etc.), and eventually gained some negotiating leverage. The workers’ pay went up (either directly or by shortened hours). The mine made a smaller profit.
For sure the mine owner is now motivated to make capital improvements, to try to get more productivity out of his more expensive workers. But it isn’t an absolute requirement. Perhaps the workers are still making less than their marginal product!
Your argument is more or less: union workers who make more money must be more productive, because the pre-union workers were being paid their marginal product, and it is impossible for labor (as a whole) to be paid more than marginal product. But what if the pre-union workers were being paid less than their marginal product? I think in the real world (not the model world) that is a quite common circumstance.
Of course salaries aren’t set by marginal product calculations. Salaries are set by what the market will bear, but no more than marginal product (or the business won’t work). But less than marginal product is fine. You say that won’t happen because of competition, I guess because a competing business will emerge and steal away the workers. But in the real world we’re talking about large entrenched businesses. Does that say that Walmart must be paying marginal product because if they weren’t, another business will emerge to steal the employees? A small business can’t compete because of economies of scale. And a large business takes years and billions to develop. If I were a low-paid Walmart employee I’d have more faith in a union to protect my salary.
Note that although labor as a whole cannot earn more than marginal product, a few workers certainly can. I think your assumption that CEO’s are generally fairly paid is just way off. Where is the market competition that pushes down on the salary of the overpaid CEO of a large company? If you see a fair and well-functioning (and nearly infinitely subtle) market operating there, then I have a blind spot that I’d like to sell you!
maxk
Oct 1 2014 at 12:22am
Of all the solutions that I’ve seen to the problem of lagging median salaries, by far the best is Scott’s: the Fed should keep NGDP on pace, and thereby keep demand high and employment tight. Tight employment gives workers leverage, and that will raise salaries.
I’m amused that Scott is a strong proponent of the best solution to a problem that he doesn’t admit exists!
In my darker moments, I wonder if tight money is favored by people who don’t want employment to be tight because they don’t want workers to have leverage.
maxk
Oct 1 2014 at 12:27am
Of course Goldman doesn’t rely on the salaries they pay their janitors to keep them from pulling confidential memos out of the trash. They don’t pay enough for that! They shred the memos.
Goldman pays their janitors more because they are in a very high rent business and can afford to share some of the largesse. The point is that it isn’t a marginal product calculation.
jj
Oct 1 2014 at 1:21pm
Goldman is in a high-cost location. In addition to being willing to pay more for quality, they have to pay more just to get the same quality as non-NYC firms.
Floccina
Oct 2 2014 at 4:13pm
The words we use often through people off and sometimes come off as insulting. When some economist says USA workers are X times more productive that workers in China they do not mean that USA workers better people or even more intelligent or skilled or better employees, they mean in the jobs that they are in in the overall economy that they are in they produce more.
Conversely someone with say that some low skilled workers are not worth minimum wage which is insulting, what he should say is that there are not enough jobs that produce enough money for firms to bid these workers wages up.
For example I think that if all people in the USA with income above average, paid to have their yards gardened extensively and ate all means out that low skill wages would be bid up.
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