The Subtle Cruelty of Efficiency Wages

One of the more sophisticated arguments for minimum wage stems from the Efficiency Wages Hypothesis (EWH).  The EWH asserts that firms will sometimes pay higher-than-market wages for their workers.  These wages reduce turnover and increase productivity, making the wages more viable for the firms.  However, it is important to note that with EWH, there is still unemployment in the industry: higher-than-equilibrium wages reduce quantity demanded and increase quantity supplied from the equilibrium point, creating a surplus of labor (unemployment).

Minimum wage activists will cite the EWH for reasons for the minimum wage, claiming the reduced turnover and increased productivity is a positive for the firms.  That much is true.  But how does the EWH increase productivity and reduce turnover?  Workers may be feeling better with a higher wage, so they’ll naturally work harder.  That’s possible.  But the real reason is the cost of losing the job is now higher.  With persistent unemployment in the industry, the threat of firing forces workers to work harder in order to keep their jobs (thus increasing productivity).  Turnover is reduced not out of some sense of loyalty to the firm now paying higher wages but because there are fewer jobs available and they are being competed for by more workers!  

In short, an Efficiency Wage (especially if legally mandated like the minimum wage) gives employers more power over workers; it reduces worker bargaining power and reduces worker ability to leave if conditions are unfavorable to them.

The minimum wage is a very cruel policy.  The minimum wage as an efficiency wage is even more so.

Ruminations on Equal Pay Day

Today is Equal Pay Day, which means two things are certain: 1) some groups will be arguing that the pay gap is very real and must be addressed and 2) some groups will be arguing the pay gap is a myth and should be dismissed.  Both groups are simultaneously right and wrong.  It is true that, adjusting for various economic factors, much of the pay gap goes away (Group 2 is correct).  However, it is also true that there is some gap that remains which could be due to discrimination (Group 1 is correct).

But economics is limited in this story.  We can provide economic explanations, but there are other factors that other fields could provide insight into as well.  For example, why is it that there is an unadjusted 80-cent gap to begin with?  Are women encouraged to avoid the higher-paying fields?  Sociology could help answer that.  Are women just worse negotiators then men?  Psychology could help answer that.  Are the biological differences that could account?  Biology could help answer that.  Is there legislation that encourages discriminatory hiring practices?  Legal studies can help answer that.  These various disciplines could provide valuable insights.

A mistake I think many economists make (myself included) is sometimes thinking the economic way of thinking is the only way of thinking.  It is powerful, to be sure, but it is not alone.  We can help provide some answers (like on the pay gap) but not all the answers (nor should we.  Division of labor).

My two cents on the pay gap: Is discrimination an explanation for the difference between men’s and women’s pay?  It’s probable; the size of the effect is difficult to know.  Unlikely responsible for a large portion.  Is government the solution?  Possibly.  If the issue is poor incentives from legislation, then government would have to repeal such legislation.  If there are other causes, governmental interference would likely cause more harm than good.

I think the pay gap deserves more thought than many economists are willing to give it, and it especially deserves thought from the sociologists and legal scholars (my gut feeling is that is where we will find much of the gap explained).

Throwing Out the Baby With the Bath Water

At Cafe Hayek, Don Boudreaux highlights a new paper by Jonathan Rothwell challenging the findings of David Autor et al that trade with China is harming American workers.  The abstract of the paper sounds interesting, but I want to focus on one point in particular (Emphasis mine):

At the community level, Autor, Dorn and Hanson (2013) find that local areas have experienced slower job and wage growth and higher unemployment because of import competition with China. Upon analyzing their data, I conclude that their results are biased by the weaker macroeconomic performance of 2000-2007 relative to the 1990s. When I analyze inter-local area economic changes — rather analyzing changes within and across areas — I fail to reject the null hypotheses that import competition has no effect on wage or employment growth, except within the manufacturing sector during the most recent period, or that it has no effect on many other outcomes, including labor force participation, intergenerational mobility, and mortality.

There’s an interesting lesson to be learned here, beyond just what Rothwell finds:

Findings can depend on how one slices the data. To wit, Autor et al find significant negative effects when the data is within or across areas and Rothwell finds significant positive effects when the data is inter-local area. We see the same in minimum wage (time series vs panel data, etc).

Any statistician can tell you that regression models can change depending on how you cut and categorize the data: different “n” can give different outcomes, different controls and dummies can give different signs, etc. We try for robustness, but it is still at the end of the day a model.

Of course, none of this is to disparage the work of Autor et al or Rothwell, or even econometrics in general (an important field, if used correctly). But we need to fully understand its limitations and our own assumptions, and be very careful before tossing out theory.

Gordon Tullock, in his 1967 paper in the Western Economic Journal, demonstrates exactly this.  Tullock begins with a conversation regarding welfare costs from monopolies and tariffs, citing recent research that finds these welfare losses are pretty minimal.  In fact, they’re so small that Tullock finds:

Judging from conversations with graduate students, a number of younger economists are in fact drawing the conclusion that tariffs and monopolies are not of much importance.  This view is now beginning to appear in the literature.

Does this mean our theory about trade and tariffs are wrong?  Does this mean tariffs can be helpful, or at least not substantially harmful?  Does this mean microeconomists spend too much time focusing on tariffs at the expense of other topics?  Or is it a measurement issue and the theory is fine?  Tullock explores this issue and finds it is a measurement issue, not a theoretical issue.  In other words, our tools not theory were incomplete.  Tullock explains in the article the need to factor in lobbying costs which do not show up in the standard welfare analysis but are nonetheless substantial (read the article for yourself to see his argument.  It’s short, 9 pages, and not technical at all).

Had Tullock not looked beyond the initial challenge to trade theory, had he (and other economists) just thrown off the theory based upon the small welfare losses, the world would be a far worse place.  As it is, his (and Jim Buchanan’s) explorations eventually lead to the field of Public Choice and provided us with a cleaner understanding on the theory of trade, tariffs, monopolies, politics, and the costs associated therefrom.

The story of Gordon Tullock in the 1960’s is why anyone should be weary of claims that theory of any kind is “mistaken” or “proven wrong” by this or that study.  We see this all the time with minimum wage.  The good economist (or scientist) will ask the question, as Tullock (and Mundell) did back in the 60’s: Is the theory invalid, or our tools?  It may be the theory is (such as with the case of geo-centrism) or our measurement tools are lacking.  In fact, we see this with regards to minimum wage: measurable job losses may be minimal, but there are many other margins firms adjust along, not all of whom are measured.  It would be mistaken to toss out the theory.

Economics is still a young science.  I suspect, as has already happened, some of our theories will be tossed out as we gain more insight and knowledge.  But we musn’t be too hasty in doing so (especially when there is political pressure to do so), lest we sacrifice knowledge for convenience and insight for what my professor Thomas Startmann calls “naive analysis.”

An Economist’s Dream

It’s not often one gets so many economic fallacies contained in one area, but this article in Bloomberg is one of those rare instances where we do.  Rather than quote relevant areas, I’ll just let you read through it; it’s short but contains many mistakes.

There are several econ 101 problems the author makes this article:

1) the first two charts are meaningless. Looking at total unemployment and total wages and not minimum wage unemployment and wages, obscures the truth. For example, if a minimum wage worker was laid off but two new CEOs were hired, then the unemployment rate would fall and real wages would rise. The cost of the minimum wage would be hidden by the hiring of the CEOs.

2) The final graph is the clincher: the minimum wage, at $11 is well below what the workers were already making! According to the graph, they’ve earned well above that for at least a decade! Since the minimum wage was set below the market rate, then it wasn’t “binding”, which means it wouldn’t have had an effect because workers were already earning more!

3) Assuming away my first two points, there is still nothing conclusive. Laying workers off is just one of the margins employers can adjust to a minimum wage hike, and it’s one done more in the long term than the short term (see work by David Neumark). In the short run, which this change represents, employers are more likely to adjust by cutting hours, benefits, or supplementing with capital equipment (to the extent they can). There are many margins they can adjust along. To look only at unemployment (and especially so in such a flawed manner such as this) is mistaken.

4) My final point is one must remember to look for the “unseen” job losses. These are hard to measure but still very real. Let’s say, for example, a business owner was going to expand her store, and to do so needed 4 extra workers. The hike goes into effect. It is now cheaper for her to hire 3 workers and have one machine to augment them (prior to the hike, the relative cost of the machine was too high). The official employment statistics would count this as 3 jobs added, but not count the one job lost. That job was very real, but now it’s gone.

 

On (Im)Perfect Subsitution

Another Econ 101 mistake people make, especially with regard to immigration and international trade, is some form of “foreigners (immigrants) can do all the work we do but for much lower prices!  Without subsidies/tariffs/minimum wage, they’re just going to take all our jobs!”  Other versions of this include “if a bunch of immigrants enter the nation, they’ll drive down wages!  Law of Supply and Demand!”

Both the above arguments make the same mistake, namely they assume foreign labor is a perfect substitute for domestic labor.  They treat all labor (or all low-skilled labor) as a homogeneous blob, one part easily replaceable with another.  But, alas, that is not the case, as price theory can show us.

Looking simply at the wages of laborers, we should ask the question “why do immigrants/foreigners command lower prices than domestic workers?” The fact that there hasn’t been wholesale replacement of domestic labor with foreign means we can rule out any cultural/biological/cost-of-living reasons such as “lower cost of living in 3rd world” or “they have a lower standard of life and thus demand lower pay” etc.  If this were indeed the case, domestic companies could just pack everything up and ship it overseas (that is, stuff that can’t be staffed by immigrants) and make tons of profits (while I have no doubt some people believe that is what is happening, the data say otherwise).

What’s more likely is that foreign workers and immigrants are simply less productive than domestic workers.  Immigrants coming into the country, legal or otherwise, face major barriers, not the least of which is the language barrier.  The manager at McDonalds cannot simply fire an American order-taker making minimum wage and hire a foreign worker for half the cost. The foreigner, simply by virtue of not knowing the language, will be less productive, thus his lower salary.  A similar argument for offshoring can be made: foreign workers, by virtue of less capital augmentation, will be less productive and thus command lower salaries.

In short, foreign workers/immigrants are not perfect substitutions for domestic labor!

It may make sense for some firms to replace/augment domestic labor with foreign labor, but the mere fact it is cheaper is not the reason why.  David Ricardo’s powerful idea shows there are times it is prudent to replace more productive resources with less productive resources, but to do so on a large scale with disregard to opportunity cost is a recipe for disaster, and why firms and individuals do not do it.

What Human Action Can Tell Us

As Ludwig von Mises taught way back in 1949, economics is, above all, the study of human action. The two main assumptions of economics back this up: 1) economic actors are rational (that is, with the knowledge they possess, they are working toward some goal), and 2) economic actors seek to improve their conditions (that is, their goal is improvement of wealth, utility, happiness, etc rather than the reduction of such).  Essentially, these assumptions boil down to: people, generally speaking, know what they’re doing (as the incomparable Walter Williams likes to say: “never assume someone is stupid until they prove themselves otherwise”).  One should deeply consider these two assumptions as what follows is derived from them.

The study of human action in the present can provide us with important insights. In this author’s opinion, I fear this study of present conditions is not done enough by economists.  Many economists focus too much on the future (what will the effect of this policy be, etc) rather than an analysis of the current situation.  Current-situation analysis can provide us insights into the future, too.  For example, an oft-heard defense of minimum wage is the “efficiency-wage theory,” that is, employers, when faced with a mandatory higher wage, will increase the productivity of their workers through training or other programs in order to meet the new wage.  Any lost profits from the higher wages would be offset by the higher profits from the increased productivity.  However, given the two assumptions mentioned in the first paragraph, we can look at the current situation and question the validity of the prediction: if employers could already increase productivity (and thus their profits) of workers, why aren’t they already doing it?  From this point, this current-situation analysis, should the conversation begin, rather than the future-situation analysis of a post-minimum wage world.  We should be further skeptical of any answer to the current situation question that involves tossing away one or both of the two main assumptions discussed in the first paragraph.

The current-situation analysis is also helpful in understanding why institutions and law pop up where they do.  Why was a private-property rights regime adopted in one area but not in another?  Why do people in New England act a certain way compared to people in North Carolina?  And so on.

The current-situation analysis prevents us from falling into the pretense of knowledge problem.  For future-situation analysis, there can always be models or logical steps that can come to all sorts of conclusions (eg, the efficiency-wage theory and minimum wage example earlier). Current-situation analysis helps us avoid this mistake.

An Important Caveat

The above discussion holds most true when the acting parties feel the majority of costs of their actions.  In situations where this is not true, where the costs of an individual’s actions are diffused over a large group that may not even involve the actor himself, it becomes harder to derive a clear picture from his current-situation actions.  For example, voting.  With voting, and politics in general, the cost of the action (or, more importantly, being wrong) is diffused among a large group of people that may not include the actor himself.  For example, if a voter votes to increase minimum wage, he is not paying the cost for such an action.  Rather, he is (potentially) compelling others to do his preferred action with no or minimal cost to himself.  His action is consistent with our two assumptions, but it is not a clear picture of what his preferred action is.  In other words, we cannot draw a conclusion from his action here as we could with the businessman in the above example.  For this reason, we should be careful drawing conclusions from political actions. Rather, his actions where he bares the brunt of the costs gives us more information.

What If We’re Wrong?

A technocracy is a style of governance where experts make the rules.  America is very much a technocracy: experts determine what medicine you can take (FDA), what jobs you can hold (licensing boards), what wages you may work for (NLRB, DOL), how you may build your home (permits), what food you may eat (USDA), who you may buy from (tariffs, DOC), and so on.  Like its religious cousin, theocracy, there are heretical questions one mustn’t ask, lest the whole system of faith it is built upon collapses.  In the technocracy, that question is “What if we’re wrong?”

The beginnings of the American technocracy started with the “Progressive Era,” a time where the leading minds in the universities, the government, business, religion, and social circles fancied themselves smart enough to run American lives.  They determined they were educated enough and the American experiment in laissez-faire had failed; America needed to be ruled by them.  Armed with such scientific methods as eugenics, Darwinism, and the like, they set themselves out to save America.  The results were horrific: minorities, immigrants, women, mentally ill or retarded, and all those deemed to be weakening the Anglo-American race were kept out of the workforce and forcibly prevented from reproducing (forced sterilization was a common practice during the Progressive Era).  Legislation like minimum wage was passed to prevent minorities from working. Mixed-race relations were strictly forbidden to prevent “race suicide.”  And these are just some of the crimes committed in the name of technocracy.

We now know eugenics is bunk, but lest we make the mistake of saying “this time it is different” with our 20/20 hindsight, we must remember that these were the leading scientists, economists, and thinkers of the day.  This was not a small movement of kooks, but what was honestly thought to be real science. And many people suffered.

And we see the same today, even in the 21st Century.  For years, FDA and other “food experts” told us eggs were bad.  That’s been changed.  Same with sodium.  And fat.  We were told ethanol would save our environment and car engines; turns out the opposite is true.  Other examples are legion.

A technocracy is just as dangerous to the secular Man as a theocracy is to the immortal Man.  Both rely upon unassailable priests to interpret the Scriptures and who give orders that must be obeyed without question.  Both promise Heaven but deliver Hell.  And both cannot tolerate heretics and freedom of thought.

Make no mistake, the experts and those who support them likely believe themselves to be correct.  They likely do want what is best for humanity.  But they make one simple, but highly flawed, assumption: that they have reached the pinnacle of knowledge.  They all suffer from hubris, which applied to a single man is a sin.  Applied to a whole nation, it is damnation.

A technocrat being wrong can have disastrous consequences.  That is why I advocate for freedom.