≈35 minutes to read.
Why do some people earn more money than others? The overly simplistic answer from neoclassical economics is that people earn what they produce. If a doctor earns four times as much as her pastor it is because the doctor is producing four times more benefit for society. CEOs use this story to justify their large salaries. They say that they are entitled to billions of dollars because, in capitalist markets, people earn what they produce. President Bush’s chief economist, Gregory Mankiw calls this idea “just deserts” in which “desert” means “entitlement” and “just” means social justice. Mankiw thinks this theory justifies vast inequality, and that the real social injustice in America is that rich people pay too much tax because they should be entitled to keep what they produce.
But reality is not so simple because what determines income in capitalism is only tangentially related to productivity. Bargaining power determines wages. Period. Productivity is also important, but it is merely one of several factors that help determine bargaining power. If everything else were the same, higher productivity people would tend to get paid higher wages, but everything else is not the same and bargaining power is also determined by managerial hierarchy, government institutions, opportunity costs, personal preferences, and persuasive abilities.
Productivity would solely determine wages for a single person stranded on a deserted island, but most people don’t work like hermits. We are social animals and when people are working together on anything, the idea that productivity alone determines wages falls apart. Consider the parable of the Giant Turnip.
In this classic tale, every year a family produces a giant turnip in the garden. It is big enough to feed them all winter long, but when grandpa goes out to harvest it, he cannot pull it out so he asks grandma to help and they still cannot get it so they ask granddaughter too, but it still doesn’t budge. They ask the dog and the cat and they still cannot get the turnip out. Finally, they ask a mouse who pulls on the cat who pulls on the dog who pulls on granddaughter who pulls on grandma who pulls on grandpa who pulls on the giant turnip and POP! With the help of the mouse, the turnip finally comes out of the ground so they can bring it inside where it won’t be ruined by the upcoming freeze.
What is the marginal product of each person? Grandpa? Granddaughter? What is the marginal product of the mouse?
You could say that they all have a marginal product of zero because, by themselves, none of them could harvest the giant turnip. Standard marginal productivity theory would say that each of them has a marginal product equal to the entire value of the turnip because if any of them had refused to cooperate, they could not have harvested it. No matter how you define marginal product, it provides zero guidance over how much of the turnip each worker should get paid because their work is interdependent. Without a team, they produce nothing.
A physicist might object that they could theoretically measure marginal product if they had equipment to measure the amount of watts that each worker contributes. But that makes no sense because the mouse and cat have a very high metabolism and will need at least a ten-times higher ratio of turnip relative to watts than Grandpa and Grandma, who have the slowest metabolism. If we compensate them according to the watts of power each worker contributed, the mouse will starve to death this winter and Grandpa will have more than he needs. Then next year they will all starve because they won’t have everyone needed to pull up the turnip.
What really determines the distribution of resources in a group is each worker’s bargaining power. If anyone would die if they don’t get more turnip, then that is a powerful bargaining position because they will all die next year if they don’t have everyone’s efforts to harvest next year’s giant turnip. Their interdependence makes it important that each worker gets at least the minimum that they need to survive. (Sounds a bit like, “…to each according to his needs“, which can be a persuasive argument in bargaining for resources because “needs” are potent social constructs.)
Giant Turnip scenarios are rampant because most people work together in large organizations, not as autonomous, self-employed individuals. We mostly work together because people are more productive at most tasks when we work together, just as the family is more productive at harvesting giant turnips. That interdependence is why corporations exist rather than everyone working for themselves. Two heads are smarter working together than separately.
Consider a numerical example of interdependence. Suppose Joe can earn $200/day working by himself and Sally can earn $100/day working by herself. If they can earn more than $300/day by working together, then they are better off working together because they are more productive as a team. Suppose they can earn $400/day by teaming up and working together. How would they divide up the $400?
Bargaining power determines the result. According to common precepts of bargaining theory, their opportunity costs are strongly bolstering bargaining power. Joe will not accept less than his opportunity cost of $200/day and Sally will not accept less than her opportunity cost of $100/day. So Joe is likely to end up with more than half of the $400/day, and Sally is likely to end up with less than half of it. That doesn’t mean that Joe is more productive than Sally in their joint activity, it just means that he has a bigger opportunity cost and that gives him a stronger bargaining position.
Suppose Jose comes along and he can perform Joe’s work equally well, but Jose’s opportunity cost is only $100/day. Then Sally could cut Joe out of the deal and partner with Jose because Sally’s bargaining power is higher vis-à-vis Jose. Because Sally and Jose both have the same opportunity cost, they could likely agree to split the money equally, which will increase Sally’s wage. Sally’s productivity didn’t increase when Jose arrived, just her bargaining power increased and that increased her wage.
A university economics professor like myself probably gets paid more than the custodian who cleans our main campus building where I work. Does that mean that my marginal product is more than the custodians? Not at all. If I left and nobody could replace my contributions, Bluffton would lose a few students, and I’d like to think that the revenue that the University would lose is more than what they pay me, but the University would continue to function just fine. They would still have hundreds of students that remain even without me and all the work that I do. But if the custodian would leave and they could not replace her work, the University would soon shut down entirely because nobody would want to come to a school where the toilets stink and the classrooms are filthy. Objectively, the marginal product of the custodian is higher than the marginal product of any professor, but the custodian gets paid less because of lower bargaining power.
The custodian is in a situation like Joe competing with Jose. There are simply more people that compete for custodial jobs than there are economics PhDs who compete for professorships. About a quarter of economics PhDs work for corporations where they earn double what I get paid, and that opportunity increases my opportunity cost. Most custodians do not have that kind of opportunity cost to increase their bargaining power.
Furthermore, a doctorate is a kind of license to teach that reduces competition for professors. Almost 100% of the workforce could legally work as a custodian because that job doesn’t legally require any certificate. But only 2% of the American population has a PhD and probably about 1/10,000 Americans have an economics PhD.
The marginal product theory of wages would only be plausible for people who work completely independently of other workers, but most people do not work by themselves. Most people work for a boss because of economies of scale. Only 6.7% of American workers were self-employed in 2012, and many of them were not working alone. Many of them hired employees or worked with family members in a team. By any measure, nearly all Americans work in a team, so there is a Giant Turnip scenario for dividing up team profits and marginal productivity cannot explain wages.
Even self-employed people like taxi drivers and hairdressers who work independently of a boss are still interdependent with the rest of the people in their national economy and that interdependence at the national level is more important than individual productivity for explaining wages from one nation to another.
The Giant Turnip of nations
If all people worked as independent contractors, then that would reduce the Giant Turnip scenarios, but they would still be there because we live in nations and all people within the borders of a sovereign nation are still incredibly interdependent. If you cross the Rio Grande River from the US into Mexico, the climate and culture and language is largely the same on both sides of the border, but people doing the same job on one side of the river earn more money than people on the other side of the river. The same thing is true if you cross between North Korea and South Korea or between Singapore and Indonesia. There are vast differences in wages across these artificial political borders that individual productivity can not explain.
For example, why do taxi drivers and hairdressers make ten times more money per hour in California than in Guatemala? They don’t work ten times faster nor serve ten times more customers. It is bargaining power again. American taxi drivers aren’t ten times more productive than Guatemalan taxi drivers but they could work in American factories and American factory workers are over ten times more productive than Guatemalan factory workers (on average) so that increases the opportunity cost of being a taxi driver in America. To get someone to drive a taxi in California, you need to pay as much as they would earn in one of the highly productive factories nearby.
American taxi drivers also have more bargaining power than Guatemalans because of immigration policies that make it illegal for Guatemalans to work in America. That limits competition in the field. Surprisingly, the evidence suggests that most American taxi drivers would NOT be poorer if there were more immigration of taxi drivers from Guatemala, because what has happened historically is that most American taxi drivers would switch to another occupation that pays better when immigrants take their jobs because native-born Americans have more occupational choices than low-skilled immigrants.
For example, my parents-in-law worked in California as migrant farm workers for one year. Those used to be considered well-paid jobs! But immigrants have displaced native-born Americans in seasonal agriculture. That helped grow the economy, which created even more jobs that are higher-paid up the economic ladder.
Regardless of how much immigration has helped most American workers or hurt others, the point is: wages are not determined by productivity but by bargaining power and immigration can transform bargaining power within national borders.
Even when there are completely open borders, there are numerous other barriers that would still limit competition between Guatemalan and American workers. Most Guatemalans don’t want to work in America even though the pay is much higher here. Similarly, wages for hairdressers and waitresses are probably more than double in New York City than in rural West Virginia, but most rural West Virginians don’t want to move to the big city. The two places are only separated by an easy day’s drive, but informal barriers produce an enormous wage gap between the two states. It is far from perfect competition and those barriers to mobility cause different bargaining power of workers in different locations.
Marginal productivity theorists would have you believe that a waitress who moves from West Virginia to NYC would suddenly become twice as productive, but would the waitress’s contribution to real GDP really double? In other contexts, economists would say this is just a change of price (as in inflation), not a doubling of real output. There is no change in productivity if someone is doing exactly the same work and just gets a wage that is twice as big.
Similarly, American hairdressers are not more productive with their scissors than they were a century ago, but wages have dramatically risen because their opportunity cost has risen. This is sometimes called Baumol’s cost disease which has caused rising wages for string quartets and educators too. It has nothing to do with their productivity. They get higher pay because the productivity of the average American manual laborer has increased fiftyfold over the 20th century according to Peter Drucker. That has raised the opportunity cost (and bargaining power) of jobs with stagnant productivity like like violinists and teachers.
Marginal productivity theory does help explain why some nations are richer than others. America is richer than Guatemala mainly because America’s average worker productivity is higher than Guatemala’s and higher average productivity potentially helps raise all incomes, just like harvesting a bigger giant turnip would helps raise all incomes. The total group productivity of working together often matters more for determining each person’s pay than each person’s productivity matters. Total group productivity matters at both the national level and the firm level in the same way. The total productivity of a firm helps determine the pay of each individual in that firm, regardless of each person’s productivity.
Technology and the Giant Turnip
Consider what happens if a smart employee figures out how to automate her own job. There are several cases where an employee has figured out how to write a computer program to do their job. Then they could spend a few minutes running the program each day and goof off the rest of the day. Eventually, they got bored and told their boss that they had automated their work.
In at least one case, the employee got fired for goofing off for a while before telling the boss about the technological improvement. The worker got fired even after contributing a permanent increase in the company’s productivity! The owners had more bargaining power than the employee in each of these stories, so the owners got most of the benefit once they found out about the increased productivity. In these cases, the workers could do almost twice as much work as before automating the job, but no employer offered to pay any employee twice as much for doubling productivity.
These anecdotes may seem frivolous, but this is actually the biggest problem with the marginal productivity theory if you stand back to get the big picture about productivity. Over the past century, most of the increase in productivity is due to improvements in technology, as is the case here. Who should get the pay for technological productivity growth? The inventors? That only happens if an inventor can get bargaining power via patents or other barriers to exclude competition from using a new technology.
Over the past century, we have been lucky that workers and owners both shared the benefits of technology, but suppose there are new technologies in artificial intelligence in the future and the benefits happen to flow to capital owners rather than to labor. If artificial intelligence finally makes robots into perfect substitutes for labor, then most workers could starve. It will be a bit like what happened to horses who mostly died off when automobiles destroyed demand for horse-drawn carriages.
The Giant Turnip scenario of exchange
We create economic value whenever two people voluntarily exchange something. Suppose discover a raw diamond on a beach that I value at $500 and a jeweler values it at $1,000 because she can shape it and make it more beautiful. If we exchange the diamond, it would be highly productive. It doubles the economic value of the diamond to move it to the jeweler, who can use it more productively. How does the $500 of productivity get divided? According to the marginal productivity theory, we should divide the money according to the relative productivity of me and the jeweler, but really this is another Giant Turnip scenario because we are interdependent. Neither one of us creates exchange value without the other, and bargaining power is the only thing that determines how we divide the income of the exchange. If I get a price of $900, then I’ll earn $400 over my opportunity cost of keeping the diamond and the jeweler will get $100 profit from the exchange. Or if bargaining power is reversed, then the income shares will reverse. There is nothing to do with relative productivity here. It is purely bargaining power over the value that we produce jointly through the exchange.
Every story of exchange is a simple version of the parable of the Giant Turnip except with only two people instead of multiple characters. The value created by any exchange between buyer and seller is interdependent and the buyer and seller jointly produce the value of every exchange. Then the buyer and seller divide that value between them according to their relative bargaining power.
A Giant Turnip scenario with labor and capital
The narrowest definition of capital means tools, machines, structures, and other built equipment that make us more productive. A simple example of capital is a shovel. In 1834, Longfild argued that the owner of a shovel should get most of the pay for work that is done with it:
If a spade makes a man’s labour twenty times as efficacious as it would be if unassisted by any instrument, 1/20 of his work is performed by himself and the remaining 19/20th must be attributed to the capital… A labourer working for himself would find it for his interest to give 19/20th of the produce of his labor to the person who would lend him one, if the alternative was that he should turn up the earth with his naked hands; or if he worked for another, his employer might pay a similar sum for the purpose of supplying him with an instrument. (quoted in Pullen, 2010)
Longfild is really talking about bargaining power here and not productivity. If a shovel owner has a monopoly on shovels, then this would be a realistic example of the owner’s bargaining power. But the productivity of the shovel is interdependent with human labor and if a laborer could get a monopoly on muscle work, then this laborer could argue that he should get all the product of his labor because the marginal product of the shovel is zero without a worker. The two opportunity costs thus only provide the two most extreme possibilities for dividing up the pay and other bargaining forces will determine the exact division. So the worker’s income will be between all the worker’s output and only 1/20th of the worker’s output.
100% > w > (1/20 = worker’s opportunity cost)
The rest of the output will be paid to the owner of the shovel. Almost all of the productivity (19/20) in this example is interdependent with the collaboration of a laborer and the owner of the shovel.
A tale of 2 unions
Suppose you have a union that has two members vs a union that has 2 million members. Which is going to have higher wages? Obviously the bigger union because it is more productive at bargaining.
Economists usually divide economic power into two broad categories: labor vs. capital. Capital, broadly defined, is wealth. People can only get income either by working (from their labor) or by owning stuff (from their capital). That’s it.
One miracle of capitalism that separates it from pre-capitalism is the formation of corporations. Corporations are like unions for capitalists (people who make money from owning wealth). A corporation allows capitalists to pool their bargaining power and elect a representative who will use their bargaining power to generate higher returns on their wealth.
Everyone who owns stock is technically at least a little bit of a capitalist, but not all capitalists are created equal. Corporations are governed through democratic voting, but it is a peculiar type of democracy that awards votes in direct proportion to dollars, so some capitalists have billions of times more power over corporations than other capitalists. Because of the extreme inequality of capital ownership in capitalism, only a small percent of people get more money over their lifetime from owning stuff than from working. Those people are usually called ‘capitalists’. Those of us who make most of our money by working (for capitalists) are usually called ‘labor’ although for high-income people, the dividing line can often get blurry.
So bigger unions will get higher wages (everything else the same) due to higher bargaining power and a corporation is a kind of union for capital that gives collective bargaining power for capitalists. Suppose you have a corporation that has pooled 2 dollars of capital versus a corporation that has pooled $2 million of capital. Which is going to generate higher income for the owners? Again, the bigger union of pooled capital. Economists justify the higher ROI for larger collective bargaining units for wealth by arguing that they deserve it because they are more productive due to economies of scale, but one reason that very large companies are more profitable on average than tiny companies is that big companies have more bargaining power in their product markets (monopoly power) and more bargaining power for their inputs (monopsony power).
One anomaly of the modern economy that would seem to refute the idea that bigger companies have more bargaining power for inputs is the fact that big companies pay more money than small companies for the same kind of workers doing the same work. The productivity story here is that big companies are more profitable which must mean that the same kind of workers doing the same work in a large company is really more productive and therefore deserves higher pay for the same work, and there is an element of truth to this, but there is also a bargaining power story that is even more important. Why would the owners of the company willingly pay more money to an accountant than that same accountant would earn at a smaller company? Here, it isn’t the accountant’s opportunity cost that gives bigger bargaining power, but the difficulty monitoring and motivating workers in larger companies that gives them greater bargaining power. It is simply easier for workers in giant companies to shirk their duties or otherwise damage the company than at smaller companies and that makes bigger companies pay more of an efficiency wage to encourage better work.
Is CEO pay determined by productivity?
As with ordinary workers, CEO pay also increases with the size of a company, but much more so than for ordinary workers. In fact, CEO pay is much more correlated with the size of a company (in revenues) than the profits of a company even though profits are the best measure of CEO productivity.
This is because a CEO has more bargaining power in a company with $100b of revenues that generates 0 profits than a company with $10b of revenues that generates $1b in profits. Although the latter CEO is more productive, the former CEO is much more likely to get higher pay. CEOs simply have more bargaining power over a $100b stream of revenues than a $10b stream because it is easier to take 1% of $100b than to take 10% of $10b regardless of the profitability of the company. And if a CEO isn’t happy, he can cause more damage at a $100b company than at a $10b company so it is wise to keep him happy!
This oddity helps explain why CEOs love to do merger deals even though corporate mergers usually end up destroying shareholder value. A CEO that merges two $10b companies is likely to get a raise even when profitability drops. Corporate mergers clearly reduce productivity (on average), but they likely increase CEO pay by increasing their bargaining power.
CEOs have a lot of bargaining power that is determined by the institutional structures of different forms of capitalism. In America, a reconfiguration of corporate institutions in the 1980s caused CEO pay to skyrocket without any relationship to productivity and then it plummeted again as institutions changed. But American CEOs are still much more highly paid than foreign CEOs and the gap cannot be explained by productivity, but it is easy to explain it with bargaining power.
For example, in countries where CEOs are monitored by elected representatives of labor who sit on the boards of directors, they get much lower pay than in America where CEOs often use their political influence within the company to get their friends elected to the corporate boards that oversee their pay. The CEO is the primary agent of capitalists and from the capitalists’ perspective, the productivity of a CEO should be determined by how profitable the company is. But CEO pay is not very correlated with company profitability because bargaining power is what determines CEO pay.
The fact that CEOs and Unions can influence wages is evidence that marginal productivity theory is bunk
Anti-union economists argue that unions get paid more than what they produce due to excessive bargaining power and that this means unions are unfair. This contradicts the marginal productivity theory because if managers are rational and their workers are getting paid more than they produce, then the company should be losing money by continuing to operate and should shut down. The fact that unionization raises wages and (almost) never forces companies to shut down is evidence in support of the Giant Turnip theory of wages and contradicts the productivity theory. But the productivity theory isn’t mainly used as a positive theory to try to describe the world accurately. It is mainly used as a prescriptive theory that justifies whatever policy for changing bargaining power that one desires.
Imagine that the marginal productivity theory were true for a second. According to theory, the shareholders and workers are all getting paid exactly as much as they produce. Now the workers unionize and they want more money. According to the theory, they would be asking for more than they produce which is akin to theft from other stakeholders in the company. Why would the shareholders continue to operate at a loss? It would be better to quit and work independently rather than continually lose money to theft. That is John Galt’s basic story in Atlas Shrugged, but this fantasy doesn’t happen in reality. The fact that unionization is almost never a primary reason that causes firms to shut down is evidence that stakeholders had not been getting paid exactly what they produce before unionization and there is considerable fudge factor for negotiating the distribution of income within firms.
If the marginal productivity theory were true for any company, then it would be impossible to unionize. The fact that unions exist proves that the marginal product theory is invalid for those companies. It is evidence that supports the Giant Turnip theory instead.
Other examples why wages are not determined by productivity
Even those few people who work autonomously as sole proprietors are rarely in perfect competition. A growing share of the labor force are working in industries that require licensure which limits competition. That includes many sole proprietors working as hairdressers, auctioneers, electricians, plumbers, real estate agents, and dozens of other occupations. Licensure increases bargaining power by limiting the competition much like unionization does.
The night shift of factory work always has lower productivity that the day shifts because workers make more mistakes at night and are not as fast and efficient due to biological circadian constraints. Marginal productivity theory would predict that the night shift should be paid less than the day shift, but the opposite is true. The night shift gets paid more because they have more bargaining power. The opportunity cost of working at night is higher because people value sleeping at night so highly and that increases their bargaining power at night to get more money than the day shift.
Uber has been lowering the rates paid to American drivers. There is no evidence that Uber drivers have lower productivity, but it could be due to a change in bargaining power. Uber has achieved more monopsony power over workers after driving away competition by bankrupting traditional taxi services. That reduces the opportunity cost for many drivers because they no longer have much alternative to work in the traditional taxi industry.
Why haven’t other economists noticed the flaws in the productivity theory of wages?
When I first “discovered” the flaws of the productivity theory of income, I was excited to be able to make a new contribution, but I soon noticed that numerous other economists had already smacked down the theory. It is a zombie theory that just keeps going and cannot be killed because it is already dead, but it continues to dominate anyhow.
- It was extensively criticized when it was first invented in Western thought in the late 1800s by John Bates Clark and others.
- It was rejected by the institutionalist economists, Marxists, Sraffians, etc.
- Joan Robinson critiqued it in 1967
- Lester C. Thurow found it empirically lacking in 1968
- John Pullen wrote an excellent book about Giant Turnip scenarios in 2010, entitled The Marginal Productivity Theory of Distribution
Surprisingly, all economists agree that when push comes to shove, workers’ bargaining power is more important than productivity for determining wages. It turns out that the real use of the productivity theory is to give a moral justification for whatever income distribution anyone wants to claim is the “natural” amount of “productivity” as explained below in discussing that it is really primarily used as a moral theory for justifying income distribution, not a descriptive theory.
Why has such a flawed theory dominated economics for over a century?
There are three main reasons why the productivity theory of wages is attractive. It provides 1. Practical value, 2. Aesthetic value and 3. Moral justification for desired levels of inequality.
1. The practical value of the productivity theory of wages
Productivity does HELP explain wages so it has been a somewhat useful theory. The problem is that every economy’s workers are interdependent with other workers and with capital owners and the Giant Turnip scenario means that it is impossible to measure individual productivity when some of production is jointly produced. What really determines wages is bargaining power and productivity does boost bargaining power because the upper bound of the wage is the perceived productivity of each worker (“MPL”) and the lower bound of each worker’s wage is their opportunity cost:
MPL>w>(worker’s opportunity cost)
Where exactly the wage will be is determined by coercive power and other forms of influence. Social institutions like property rights, contract law, and other rights are a big source of coercive power that affects wages. Information is another important source of bargaining power because if a worker can convince employers that she has a higher MPL and/or a higher opportunity cost, she can bargain for a higher wage. Or if an employer can convince workers that a non-compete agreement in their employment contract is valid when it is actually unenforceable, the employer can gain more coercive leverage. Coercion and imperfect information are both always present to some extent in every economic exchange and they affect how wages and capital earnings are distributed between people, and for workers one of the important factors really is productivity (MPL).
So MPL is somewhat useful for explaining wages because it would set the maximum a fully-informed employer would be willing to pay and the higher one’s productivity, the higher one’s bargaining power, ceteris paribus. But it is only one of several important factors that explain wages.
2. The aesthetic value of the productivity theory of wages
Mathematical economists prefer the productivity theory because it is much simpler to use than bargaining theory and it is much more convenient for making the mathematical models of the economy that economists love to do. There is a certain beauty that some mathematical models have and the math of marginal productivity is more elegant than more realistic models. Humans have a well-known bias to think beauty is a sign of truth.
3. The moral justification for desired levels of inequality of the productivity theory of wages
There are two reasons why people desire the productivity theory for morally justifying incomes: I) the just-world fallacy, and II) Elite self-interest.
I. The just-world fallacy as a motivation for the productivity theory of wages.
Normal people have a tremendous wish to see justice in the world and when we look at any situation, we seek a moral explanation to justify the outcome. Philosophers have discussed just-world bias for millennia, but it was first experimentally tested by Melvin Lerner in the 1960s when Lerner built upon Stanley Milgram‘s shock experiments. Lerner found that when people saw others getting electric shocks, they tended to blame the victim for getting shocks and the greater the shock-induced suffering, the greater the blame. They made sense of the suffering by rejecting and devaluing the victims which is an example of a fundamental attribution error. But when the victims were getting paid for their suffering, then participants stopped derogating them because the payment made the suffering just and they felt no need to invent a reason why the victims deserved to suffer.
Just-world bias is one of the causes of status-quo bias because if the status-quo is just, there is no reason to want to change it. The productivity theory of income is the way economists and many Neo-liberal thinkers achieve a just-world story about the status quo nowadays, but before the productivity theory, there have been a host of other dubious ways to justify the distribution of income.
Many religions have suggested that God determines who is rich and who is poor. For example, the prosperity gospel is a modern movement that has made the productivity theory of income into a religion. According to the prosperity gospel, God rewards faith with riches and the richer you are, the more God has blessed you. Before the prosperity gospel was the divine right of kings which claimed that the nobility, who owned virtually all real estate, deserved absolute authoritarian control over everything because God had anointed them. Before the divine right of kings, most empires were theocracies which had the idea that the king was actually a god or at least a demigod (a divine child of gods with super-human powers).
An advantage of the just-world justifications is that it creates stability because it helps people accept whatever they see in the world and it reduces the desire for change. A disadvantage is that it increases the despondency of the disadvantaged who blame themselves for their problems rather than seeking to change the real cause.
II. Elite self-interest as a motivation for the productivity theory of wages.
Rich people (and their fans) like to use the productivity theory of income to justify the status quo and claim that we live in a meritocracy. I once heard Arthur C. Brooks deliver a brilliant fundraising speech to rich people at a Hillsdale conference. An audience member stood up at the end and said that he had been incredibly blessed in life to have made a lot of money and he wondered how he could best “give back” to society. Arthur sternly scolded him, telling him he should never say ‘give back’ because that would imply that he had taken something. Brooks told the man that, “You created every dollar that you have.” This is an application of the productivity theory which claims that everyone in the private sector earns what they deserve because they are makers. Then the takers in government take away taxes to pay for Medicare, teachers, national defense, Social Security and the like
People like Arthur C. Brooks and Greg Mankiw argue that private markets give everyone what they deserve and taxes are a social injustice. But marginal product theory is very flexible and could also justify the opposite: massive taxation. That’s because the marginal product of government is much larger than the taxation the government recieves. That is obvious because everyone would be very poor in anarchy without any government, so government, just like everyone in an efficient economy, earns less than its marginal product. (Of course I’m not trying to justify the marginal product of ALL government programs on this basis. I’m just saying that even the extremely imperfect government we have, despite its many inefficiencies, is still much, much better than anarchy.)
The productivity theory of wages is a prescriptive theory that anyone can use to argue for change.
Although elites like the productivity theory best, because it readily justifies their wealth, it has been adopted by anti-elites too. It is a very flexible theory because everyone recognizes that bargaining power is really what determines the distribution of income and anyone can imagine a different “natural” distribution of productivity.
Anti-union people claim that the “natural” amount for unionized workers to receive is lower than what the union negotiates because union workers do not produce enough to pay their wages (which makes no sense if businesses are maximizing profits). Everyone accepts that bargaining power determines wages in here, and anti-union activists claim that unions get too much because unions have excessive bargaining power. They claim (without evidence) that union workers are getting paid more than they produce.
On the other side, union supporters also used marginal productivity theory to claim (also without evidence) that non-union workers are getting paid less than they produce because corporations have excessive bargaining power to push down wages. They use it justify their claim that non-union workers are being exploited. (John Pullen, 2010, p. 2)
So both sides use the same theory of productivity=wages to argue for opposite results!
Whereas CEOs use productivity theory to claim that they deserve more money (without evidence), their detractors use it to claim that American CEOs deserve less because they are exploiting their bargaining power to get more than their marginal product (again without evidence). The one fact that everyone should be able to agree upon is that the wide variation in CEO pay cannot be explained by measures productivity.
The Giant Turnip theory explains CEO pay better. It teaches that everyone, including the CEO and every worker, is paid less than their marginal product because productivity is interdependent. Without a CEO, labor would produce nothing and without labor the CEO would produce nothing. In either case, the corporation would go bankrupt. Every company exists because workers are interdependent–they produce more working together than they could accomplish as separate individuals and that means pay is interdependent too. In an efficient company, everyone should always get paid less than their marginal product because it would increase profits to fire anyone who gets paid more than they produce (with a minor exception noted below in miscellaneous example #4).
The productivity theory is a very flexible theory that can justify widely divergent distributions of resources because it describes an imagined ideal rather than an observed reality. People just decide whatever they think someone deserves and then they call that the “natural” income and claim that is how much they are producing.
Marginal productivity theory is like utilitarianism in that they both describe theoretical ideals that are impossible to realize. Both theories make descriptive claims about the world that are impossible to measure and they are both primarily used for prescriptive ends. Nobody tries to empirically measure how much utility every person has at any given time just like nobody tries to empirically measure how much value individual workers are really producing at any given time. Measuring individual productivity is impossible because in reality, the supply chain is a series of giant turnips all the way down.
Other miscellaneous examples of flaws in the productivity theory of wages
It doesn’t match how HR professionals actually set wages. They almost never even attempt to measure marginal product. Instead they typically try to use some sort of formula that is partly determined by objective criteria such as length of tenure in the job or a change in job category (automatic raise with a promotion) or a comparison with what other firms pay for similar workers. They also use subjective criteria, but that is rarely a direct measure of marginal product either. Marginal product is foreign to most of the wage determination of HR professionals.
- Companies often pay all workers in a category exactly the same wage despite the fact that some workers in any category are much more productive than others.
- Companies adjust pay only rarely (typically once a year) and they make large discrete raises rather than raise pay continuously as performance gradually increases (or decreases).
- True “performance pay” is rare. Companies often call a bonus “performance pay” but bonuses are rarely tied to individual performance as is predicted by marginal productivity theory. If wages were equal to productivity, then performance pay should be the standard way that people get paid and workers should get more money per hour for some tasks than for other tasks because real productivity varies from hour to hour and month to month. In particular, there should never be paid vacation!
- In many cases, individual performance pay produces worse performance than flat salaries.
- Information is power and HR professionals at big organizations have more information than individual workers about opportunity costs. At Berkeley University when workers were given information about their wage relative to occupational averages, many soon quit who had been paid below average wages.
- Walmart has a national wage policy which sets all wages the same everywhere by default. Stores can apply to differ from the national wage standard, but most don’t and there isn’t a corporate plan to respond to local labor markets. In reality, some stores are more productive than others and if workers were paid their marginal product, then some stores would pay more than others.
- Workers are more productive in companies with more monopoly power, but non-unionized employees of monopolies do not get additional pay because monopoly power does not change relative bargaining power much.
- Secretaries get paid more at companies where the average pay is high (like at a law firm) than at companies where the average pay is low (like at a landscaping firm) and the wage difference is much more than can be explained based on their qualities or the work they do.
- At Carnegie Mellon University, Linda Babcock discovered that male graduates were getting starting salaries that were 7.6% (or almost $4,000) higher than female graduates. This is significant money. Was the difference due to male MBAs being more productive? No, the difference was entirely due to men being better bargainers. Both men and women were offered the same average starting salary, but only 7% of the women vs. 57% of the men had asked for more money and that made all of the difference. When women were coached to bargain for more money, their take home pay rose as well.
- Companies often pay new employees the same wage in the first weeks or months while they are getting trained to do their new job and producing nothing as they pay after the training is done and the new workers finally begin producing something. Plus, in an economic recession, most firms would rather lose money by keeping idle workers that are expensive to hire and train in order to avoid the cost of hiring and training new workers when production ramps up again. This is yet again another piece of evidence against they theory that people get paid their marginal product. The standard textbook explanation is that firms will recoup their investment in training by paying less than the marginal product in the future. Supporters of the marginal product theory argue that the discounted expected value of future production should equal the total future wage bill in a competitive market, but there is no reason to think that markets are competitive enough that that would be true. This is a standard, textbook example where everyone agrees that firms almost never pay the marginal product of workers who develop higher skills over time even in idealized textbook models, so pay undoubtedly diverges from productivity much more in messy real-world examples.
- After the Black Death in Europe, worker productivity rose due to smaller population, and the productivity of land fell a little, but the wage/rent ratio skyrocketed by more than double. This cannot be attribute to actual changes in land fertility nor human work output. Farm workers did not start producing twice as much grain per year and land did not suddenly become infertile. In reality, most of the enormous changes in prices were due to changing relative bargaining power between capital and labor.
- The standard comparative advantage model determines what we do not on absolute productivity, but upon opportunity cost. A simple extension shows how wages are also determined by opportunity cost and not productivity. For example, US clothing manufacturers could be more productive per hour of work than our trading partners, but it does not matter. They still lost jobs to trade because foreign workers get a much lower wage because foreign workers have a much lower opportunity cost than American apparel workers. American apparel workers do not get ten times more money/hour than most foreign workers because they are ten times more productive, but because their opportunity cost is ten times higher and there are transactions costs that prevent foreign workers from taking their jobs. Also see the taxi-driver example above.
- Blair Fix shows that the math of the marginal product theory is based upon a flawed
accounting identity and other flaws.
- Standard economics textbooks recognize that the productivity theory is flawed because it is dependent upon the numerous unrealistic assumptions of perfect competition. I haven’t covered those numerous flaws in this essay because they are shown in typical economics textbooks like Fundamentals of Labor Economics. The marginal productivity theory assumes: 1. Profit maximization, 2. No fixed costs of capital (short-run analysis), 3. No training nor hiring costs nor fringe benefits, 4. All workers are exactly the same, 5. Perfect competition for labor (nobody can negotiate wages – they just assume that there is zero bargaining power!), etc. Needless to say, none of these assumptions are true although some are much more ridiculous than others. It is completely ridiculous to assume that nobody has any bargaining power, but it is relatively benign to assume profit maximization. Although firms do not totally maximize profits, at least there are strong incentives to do so. And for the same reasons, there are also strong incentives for everyone to increase their bargaining power!
The following saying shows how productive a small thing can be.
For want of a nail the shoe was lost;
For want of a shoe the horse was lost;
For want of a horse the battle was lost;
For the failure of battle the kingdom was lost—
All for the want of a horse-shoe nail.
If only the military had paid their stable boys better, they would have nailed the horseshoes more securely and that would won the war. That is enormous marginal productivity!
Why does this matter? Bad theory leads to lower productivity.
The productivity theory encourages greedy self-interest which is bad for organizations. Organizations need people to work together. The whole point of being in an organization is that working together is more productive than working as individuals. If people were more productive working alone they wouldn’t work together in organizations because they would be able to get higher pay working by ourselves and have the blessings of higher autonomy too.
Selfishness is corrosive in an organization and productivity theory makes each worker focus on what I produced and what I deserve rather than on what we can accomplish together as a team. As every coach knows, there is no I in ‘team’.
Productivity theory teaches that everyone deserves to get paid what they produce, but each person always gets paid less than their marginal product. That leads to productivity-sapping resentment and it feeds each person’s natural tendency to have self-serving bias that we tend to think that we contribute more than other people think we contribute. Richer, more powerful people tend to suffer more from superiority bias than less powerful people and it is corrosive to society.
If everyone tries to bargain for their marginal product, they will end up wasting resources in the tragedy of bargaining because adding up the marginal product of every person is always greater than the total product of every organization.
The productivity theory of income makes rich people look down upon poor people and makes poor people self-loathing &/or resentful. This is bad for business because everyone is more productive when they feel like they are part of the same team and if the elites in an organization look down on the workers at the bottom of the pyramid, they will hurt morale at the foundation of the business.
For example, in hospitals where doctors treat the custodial staff with dignity, the custodial staff believe that they are an integral part of healing people, and they are. In hospitals where doctors avert their gaze rather than greeting custodial staff as if they are untouchables because they only earn 1/10th as much as a doctor, the custodial staff will have low morale and treat patients worse and clean less efficiently.
The productivity theory of income is also bad for society. Michael Sandel’s book, The Tyranny of Merit argues that the rise of populist movements on both the Left (Bernie Bros) and the Right (Tea Party, Brexit) have been animated by anti-elite resentment that is a product of the productivity theory of income. The productivity theory reinforces elite snobbery by claiming that the millions of people who are getting left behind by rising inequality should only blame themselves as individuals. In reality, rising inequality is caused by circumstances beyond anyone’s individual control.
For example, international trade creates winners and losers even though it doesn’t change anyone’s productivity at all. The meritocracy myth puts the blame on the workers who lose their jobs and that just breeds resentment among the many losers from free trade. Economists correctly point out that free trade makes the nation richer as a whole, but that just makes the losers even more resentful because their loss is going right into someone else’s pocket.
This essay was researched with support from the Howard Raid Endowed Chair at Bluffton University and is based on a Howard Raid Lecture given in 2018
Thanks for reading all the way to the end of the essay! I wrote this for my Labor Economics students and I expect to update it in future years. Suggestions are welcome.
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