Thursday, January 12, 2017

Minimum Wages and Productivity

I had a chuckle reading a report in today’s New York Times that describes a pair of papers on the minimum wage presented at the recently-concluded economics meetings in Chicago, especially the first, an experimental study by John Horton of NYU.  Horton set up an online matching system between employers and workers, where each made wage offers for a variety of tasks that could be performed remotely.  The design allowed him to measure the actual productivity of workers in these tasks if they successfully concluded a deal with the employers.  Then he imposed a minimum wage to see what would happen.  The result was that employers sought out the most productive workers when they had to pay higher wages to everyone.  (They could estimate productivity differences from information on workers’ prior wages.)

There was lots of back and forth in the article about whether this result would generalize to a minimum wage established over all employers within a region rather than just a few (who could better pick and choose), but for me the irony is that this is exactly what proponents of the minimum wage hope it will achieve.  That is, one of the main purposes of setting a floor under wages is to generate incentives for firms to increase productivity.

Note that it is the firm that is expected to do this.  Economists for some reason tend to assume that productivity is essentially a worker attribute, like how tall you are or whether you’re left-handed.  No doubt workers differ greatly according to their potential productivity, but most actual, realized productivity is the result of the way the work is set up—whether the output is of lesser or greater value, how much and what kind of equipment the worker has available to work with, what kinds of skills the work develops and makes use of, and how much opportunity the worker herself has to tinker with the job to make it go better.  These are employer choices.  In a world of low wages employers have less incentive to invest in the productivity of work, so they don’t.

This argument will hardly come as earth-shattering news to development economists and economic historians.  One of the arguments why the industrial revolution first occurred in Europe rather than China, for instance, is that the possibility of emigration prevented European labor from being as abundant as Chinese, with correspondingly higher wage costs.  A major factor in the explosive rise of the US as an industrial power in the nineteenth century was the availability of cheap land, which put an even higher floor under wage rates.  This is not to say that workers had it easy, of course, just that they were significantly less destitute in some regions than others.

If increasing labor productivity is a major social goal—and it should be—then making labor more expensive is a good thing, all else being equal.  The only trick is to see that, in the modern, mechanized interdependent world, it’s the quality of the job that turns the worker’s potential productivity into the real thing.


Jerry Brown said...

"If increasing labor productivity is a major social goal--and it should be--then making labor more expensive is a good thing, all else being equal."

Well I completely agree and wonder why more economists do not speak about this. Especially the ones at the Fed, who seem to recoil at the very notion that workers might get a raise. Thank you for posting this.

Critical Tinkerer said...

My experience of having two same buisnesses in two different countries, one with low labor cost and another with high labor cost tells me how the high labor cost increases the productivity.

The first and obvious one is purely matheatical where economists (and that study showed is that cost of labor is a measure of productivity just byitself) count cost of labor as productivity measure.

But more importantly is about what costs more: tools or labor.
Labor price is fixed, i as a firm's owner can not influence the cost of labor that much but i can increase labor productivity by buying better tools and more of them.
In low labor cost environment i was not incentivised to spend money buying tools in order to increase labor productivity. It is a wash between increased productivity and buying more tools.
On the other hand, in high labor cost environment i was forced (not only incentivised) to buy more and better tools for labor to use.

Not only that higher labor costs creates higher productivity but also my buying more and better tools is increasing demand on tool makers to always invent better tools and sell them. This also increases overal agregate demand in economy.

Another important aspect of higher labor cost is that such income generates aditional demand to rpoduce and sell comparring to low wage environment. My expenses are someone elses income->buying power-> agregate demand.

Another way that productivity is increased in high labor cost environment is that workers have less economic problems at home and are more relaxed at work enabling them to think better and to follow orders better. Work satisfaction is one of the major reasons to be cooperative with the boss, beyond being forced to work to survive.

Not to talk about moral implications of having such environment where workers barely can live on full time jobs and risk catastroffe by beoming chronically ill without social protections that is normal for low cost labor environment.

Anonymous said...

Did the study take unemployment into account, with the presumed productivity of the unemployed as zero?

Bruce Wilder said...

The word you are looking for in your paragraph 3 is "manage". The firm in reality although not so much economic theory (on the Econ 101 level) manages a structured production and distribution system. The actual firm lives in an uncertain world, where people do not know everything and learning takes place as a result of errors within a deliberately albeit ignorantly chosen structure. The firm is formed by sunk-cost investment in that somewhat heuristic structure and part of the firm's income from output is risky, a residual. And, there are black swans shadowing that residual.

Stiglitz proved in a formal theorem that in a risky or uncertain world marginal product of labor would be managed to equal the wage, for what that is worth. If everyone knew everything and no one had to commit in advance of producing final goods, sure marginal product would be what it is. We do not live in that world. We live in a world where the wage is set. This is true of all wages -- minimum wages are not unique in this respect. Minimum wages protect those least able to bargain, but even those with highly valuable credentials typically agree to fixed wages, with only limited contingencies. Just notice the sequence: in ignorance we agree a wage and then management makes it so as we learn what actual output is to be.

Economists who collapse marginal product to an attribute of the individual are ignoring uncertainty and all its implications for technology and management. It is not a simple error of ideological worldview; the implications are sweeping. It is anchored in the fundamentals of Econ 101, when the production function is defined by assuming that all the technical and managerial problems are maximally solved within the ambit of available knowledge, so that the problems of allocational efficiency can be analytically isolated.

One implication of a more realistic view is that a low wage allows management to relax and "waste" labor. Some people will be employed at a low wage just in case. Employers facing a higher wage will tighten up their organisation of production, train more and reduce turnover among employees. Conservative economists typically counter that a profit-maximising employer would take advantage of such opportunities if they were available, even in the absence of the constraint of a minimum wage. But, in an uncertain world there are no profit-maximising employers because there is no such thing as profit-maximization. No one knows the "maximum" nor is a maximum discoverable. The assumption of a maximization was an analytic convenience for making a production function a function and defining allocational efficiency analytically; it was never a feature of the world. In real life, people manage at a frontier of waste and error and uncertainty and discovery.

The development economists and economic historians, who argue that high wage economies drove the industrial revolution are basically being idiots, by the way. They are trying to make the story of the industrial revolution a story of allocational efficiency, because that is how Econ 101 draws its production function. It is rather obviously stupid, not least because the industrial revolution is a matter of applying science to technical problems and leveraging literacy to organize hierarchically. Here is an idea about the English-speaking world's access to vast virgin agricultural lands: maybe an agricultural surplus is necessary to feed an urban, artisanal and commercial civilization. Maybe China failed because the did not have effective enclosure and too many hands on the farm choked off the surplus.

What is critical to an industrial revolution, aside from mechanical energy from fossil fuels, is the capacity to learn from error to better control production processes. Which is a problem of technical and managerial efficiency primarily, and allocational efficiency only secondarily.