### How Labor Markets Really Work

"Do you think there are at least 1000 workers in the United States who produce more than \$20/hour for their employers, yet they are only earning minimum wage?"

My guess would be: "Certainly."

Too many economists have no idea how companies hire people. I have done it at several places. Here's what happens:

Someone higher up in the company decides some task needs to be done. They give you the task. You say, "Well, OK, but I'll need a couple more programmers."

"How much will they cost?"

"Good Java programmers get around \$100,000 per year."

"Hmm... can you get by with one full-timer and one part-timer?"

"Yeah, I guess so..."

"OK, do it."

Most likely, no one in the company has any real idea how much this project is worth. No one has any real idea what the value of the output of these 1 and 1/2 programmers is. All that matters is whether the higher up is pleased with the outcome of the project. And so long as her superiors are pleased, and the company as a whole makes money, things can go on this way forever.

So, my guess is that there certainly are well over 1000 workers in the United States who produce more than \$20/hour for their employers, yet they are only earning minimum wage. As well as whole boatloads who earn the minimum wage but produce far less for their employers. Bob attempts to dismiss the possibility of such failures of wages to equal marginal products by saying that, if they existed, we could create "a business plan for how we can hire these 1000 (at least) people at \$10/hour, and still make \$10,000 in pure profit per hour."

There are at least two problems with the above attempt at a reductio:

1) Since the employers don't know (for the most part) who these people are we certainly can't either!

2) It is quite possible someone could make employer A \$21 per hour, but make far, far less if employed by B. The factors of production are not homogenous and are not perfect substitutes for each other.

(Ah, [some] Austrians! This point is in the forefront of their minds when they wish to critique some interventionist scheme, but when it comes to defending the near-perfect efficiency of the market, it goes walkabout.)

The same thing applies to other factors of production as well: Where I have worked, when someone "needed" a new computer, no one in the chain of approval asked "What will its marginal product be?" And no one would have known how to answer if they had. No, we justified it because, "Carl has been here two years, and yet he has the slowest computer in the group, and he's really griping about it." And the request would get approved in good times and turned down in bad times, which is absurd in a marginalist theory of how prices are set.

Final note: I am not "anti-marginalist," any more than I am against physics models that feature frictionless surfaces. I am just noting that it is an idealization, and the real world only resembles the model in a very rough fashion.

UPDATE: Daniel Kuehn notes that the "frictions" in economics are simply other margins. Very good point: as an employer, I could try to get more and more accurate measures of my workers' marginal product. But there is a margin at which they cost of doing so exceeds the benefit. I have been a companies that ignored that truth: the whole company became bogged down in an attempt to measure productivity, and weren't doing no production!

1. Gene writes: "So, my guess is that there certainly are well over 1000 workers in the United States who produce more than \$20/hour for their employers, yet they are only earning minimum wage. As well as whole boatloads who earn the minimum wage but produce far less for their employers."

Yes, I was also surprised that Bob was so sure this wouldn't be the case. I'd bet a modest sum of money on there even being 10,000 of such workers, and would still be willing to bet a symbolic amount on there being more than 100,000 so such workers (out of a total of 1,700,000 earning the federal minimum wage).

It would just be hella difficult and costly to figure out who they are (and hence to devise a way of hiring them and reaping the profits)

Gene wrote: "The same thing applies to other factors of production as well: Where I have worked, when someone "needed" a new computer, no one in the chain of approval asked "What will its marginal product be?" And no one would have known how to answer if they had. No, we justified it because, "Carl has been here two years, and yet he has the slowest computer in the group, and he's really griping about it." And the request would get approved in good times and turned down in bad times, which is absurd in a marginalist theory of how prices are set."

Yep.

"Final note: I am not "anti-marginalist," any more than I am against physics models that feature frictionless surfaces. I am just noting that it is an idealization, and the real world only resembles the model in a very rough fashion."

Yes, but it does raise the question whether and under what interpretation the two sides in the marginalist controversy might in fact not be mutually exclusive.

2. This is a really excellent post. My mea culpa is up too.

I don't think you need to be defensive about being anti-marginalist. Thinking about information asymmetries and that sort of thing is marginalist - it's just adding another margin to think about.

This case still probably isn't typical (if it were just an asymmetric information problem it really couldn't be) - and to the extent that it does exist it probably gets frittered away by internal labor markets that promote productive workers before they're lost.

1. "I don't think you need to be defensive about being anti-marginalist. Thinking about information asymmetries and that sort of thing is marginalist - it's just adding another margin to think about."

I've worked on a project related to this in a large (over 10K employees) organization, and it was very, very difficult. And we were just looking for correlations between various factors and overall profitability of units.

My guess is that most large organizations have very little idea of marginal productivity of most units, practices, and people, and just survive on the fact that the others don't, either.

3. I think this is wrong though: "And the request would get approved in good times and turned down in bad times, which is absurd in a marginalist theory of how prices are set."

That makes sense doesn't it? Marginal revenue product would be lower in bad times even if marginal product stays the same. Granted, the marginal revenue product of all factors of production would be lower in bad times, so why would it be more likely to be turned down?

Because the benefit of cash reserves would be higher.

So the company builds a reserve and doesn't replace the computer, like a good little constrained optimizer.

1. "That makes sense doesn't it? Marginal revenue product would be lower in bad times even if marginal product stays the same. Granted, the marginal revenue product of all factors of production would be lower in bad times, so why would it be more likely to be turned down?"

Or not; in good times it might make little difference, because sales of everything are good. In bad times, customers might be far more picky about whether and what they buy.

4. Gene wrote: "Final note: I am not "anti-marginalist," any more than I am against physics models that feature frictionless surfaces. I am just noting that it is an idealization, and the real world only resembles the model in a very rough fashion.

UPDATE: Daniel Kuehn notes that the "frictions" in economics are simply other margins. "

Yes, Gene was using 'marginalist' in the meaning it had as referring to one side in the marginalist controversy, namely the neoclassical (incl. Austrian) side that strongly idealizes in the way described by Gene and as such doesn't describe how actual employers make decisions, while Daniel meant it in the more general way of marginalist thinking (as in: the revolutionary side in the marginalist revolution) that may or may not involve strongly idealizing assumptions. I mean, the 'other' side in the marginalist controversy were also marginalists when that term is understood in the more general sense.

5. Wait no, that actually is incorrect. Daniel used it in the sense in which Gene used it as well, and I'm talking about something else altogether.

Anyway, carry on...

6. Good points, but working at employer A when you would be able to produce more value at a employer B is not the same as being underpaid[1] at employer A, and I think that's the far more common situation.

Employer/ee match is indeed a very difficult search process and even in the best of times and with the right incentives it operates clumsily.

The situation you've described like a situation where labor in general is harder to value because of the few available metrics, so it will indeed be determined more by very one-off factors (right place/time, negotiating skills, inattention of management, finding a teenager artificially held out of the programming marketplace, etc).

But, keep in mind, the same valuation problem applies to those publishing studies that purport to estimate (aggregate) deviation of value productivity from wages!

[1] relative to marginal value

7. I realize now, re-reading it, how my post looked. I actually wasn't "so sure" there weren't 1,000 such workers. The point of the exercise was to walk through why Warren's interrogation of that witness was so stupid. As you yourself are showing Gene, whatever reasons we can come up with to explain how the wage gap could conceivably exist, don't allow for improvement via a huge minimum wage hike.

Like I said, I'm not trying to un-say what it appears that my point was, especially since (I think) Don B. on his blog was saying what a great point it was. But I had thought of a bunch of these caveats too, yet since Daniel wasn't bringing it up (nor could I find anybody else who wanted to give me an answer so we could move the debate forward), I didn't bother arguing with my own post. I found Daniel's actual responses to be totally beside the point, a la "Sure Warren doesn't know what she's talking about, but I love her just the same."