Challenging Economics – Marginal Productivity Of Labour

Whenever there is a great debate over wages, be it the minimum wage or unions effect on wages, opponents cite the marginal productivity of labour. They argue that this prevents businesses from paying higher wages and if they did, it would only lead to higher unemployment. This theory is unquestionably stated as fact in all textbooks and the impression is given that there is an iron law of economics that fixes wages. Despite its wide use, it is completely false. The vast majority of workers do not have a marginal productivity of labour and those that do are not paid it. It is a theory that has long outlived its day and continuing adherence to it means the wrong decisions are being made.

The textbook story begins with a simple parable say, a baker making bread. The story is always extremely simple, comprising a single individual directly manufacturing a good for a clear price. So let’s say this baker makes bread worth €5. Naturally they will then be paid €5. If the government imposes a minimum wage of €6 then the baker will be fired as it would cost too much to employ him/her. Various economic terms and diagrams will be thrown in to back up the case (it will be argued that the marginal cost of the baker to the company exceeds the marginal benefit). Essentially it boils down to the easily understood concept that you cannot pay someone more than they produce. Workers cannot be underpaid because another company will have an incentive to offer them a better wage and hire them. Therefore wages are set by the invisible hand of the market and no good will come from mere mortals’ attempts to interfere with it.

However, there are many problems with this idea. While it seems common sense that a worker cannot be paid more than they produce, in actuality they are always paid much less. This is actually an obvious point that becomes apparent rather easily. You see workers cannot receive the value of their marginal productivity because if they did, the business would not earn any profit. If the above baker earned €5 for producing €5 worth of bread, then the business would have no reason to hire him as they would not gain anything from it. The only reason anyone is hired and capitalism functions is because of profit. This is not a socialist critique, but rather a point that is obvious to people of all ideologies. Those who argue that workers get paid their marginal productivity must assume that businesses do not make a profit (believe it or not, this is what textbook neo-classical economics assumes).

It gets worse for the theory. After all, labour is not the only cost a business has; it must also pay for its use of capital (equipment, buildings etc). If the baker is getting the full value of the bread, then how does the bakery pay for the ovens? How does it pay for heat and electricity? What about the dough and other ingredients? It is quite clear that absolutely no business could possibly pay their workers the full benefit of their labour. Simple observation shows that they cannot. Workers only get paid their productivity if there are no other costs of production.

The theory falls apart when employees do not work in isolation. It may be possible to calculate how much a person produces if they work alone. However, if they are part of a team and their wage depends on the collective results, then the theory has no use. A car factory is a good example. If my job is to fit steering wheels onto cars, then what is my marginal productivity of labour? What portion of the price of the car is due to me? The honest answer is that I do not know, nor can I possibly know. Sure a steering wheel is a crucial component of a car, but so is almost any part. By myself, my contribution is useless; it is only as part of a group that anything is produced. Nor can I calculate my ratio of pay compared to my co-workers, after all, is fitting a steering wheel more or less valuable than installing the tires? Or the brakes?

So far, I have discussed only manufacturing work, where the theory is at its best. However, it is invalid and unusable in the service industry (which comprises roughly two-thirds of developed economies). This is because workers in the service industry technically don’t produce anything at all. What does the checkout staff add to the products you buy? Technically, cleaning staff do not produce anything, nor do security. What is a waitresses marginal productivity seeing as she doesn’t produce anything, nor change the goods in any way? Just like the transport industry in general, they are simply moved from one place to another. They add nothing to the product, yet they still provide a necessary service and must get paid. But how do we calculate how much?

So in reality, our baker may produce €5 worth of bread, but he will not get paid €5. First of all, his business must earn a profit, after all that is why it hired him. Let’s say his boss is neither a greedy capitalist nor a monopolist, so he only takes 10% in profits. So the bakers wage is €4.50. But the mortgage on the building and the equipment must be paid. So the baker gets €3.50. Then there is the heat, light, ingredients and other running costs that must be paid. €2.50. There are the other staff in the business who do not directly produce any bread but provide necessary services anyway. There is the supervisor making sure the baker works, the checkout staff who literally sell the bread, the delivery man, the night watch guard and the cleaning staff. They of course must get paid, so the baker is down to €1.50. Finally, the company needs to advertise so that people actually buy their product as well as conduct research into new baking techniques. After all, innovation is crucial to the growth of capitalism. So this leaves our baker who produces €5 worth of bread, getting €1.

Does mean the baker is being exploited? The short answer is yes. In fact all productive members of society are exploited. I don’t mean this as a call for revolution or in a particularly Communist way, but rather as a statement of an obvious fact. The whole reason a business hires anyone is because they will make the business money. If they kept the fruit of their labour entirely to themselves, there would be no reason to hire them. We are all exploited, because if we were not society would not function. There are too many non-productive members of society that perform necessary work. I do not mean an Atlas Shrugged style division between makers and takers. Instead the world is divided between productive and socially useful. After all, teachers, doctors and police officers do not produce anything, yet they provide services that are useful to society and make us all better off.

So if few workers in the economy get their marginal productivity of labour, how is their pay determined? It certainly appears as though a lot of it is random and there is a lot of space for variance. There is no scientific method of choosing how much to pay a security guard. Therefore, it is ridiculous to assume that the free market will set the perfect price that cannot be improved upon. The use of capital will also determine it as the larger the mortgage repayments the less money there will be for wages. However, I believe the largest factor is the relative bargaining strength of each person. In other words it is the amount of power each actor has that determines their wage rate. If there are few bakers but many cleaners, bakers can bargain for a higher wage but cleaners cannot. Therefore unions, do not distort the market, but change the balance of power. A union can even the playing field between employers and employees (employers have huge power through their ability to hire and fire). If some staff get low pay due to their weak bargaining position rather than low productivity then it is possible for the government to intervene to raise their wages without harming the economy.

This is where the policy implications come in. The theory of marginal productivity of labour is popular because it claims that employees are never exploited and market forces drive wages. However, if it is really power that determines it, then there is space for unions and government intervention. Imagine if the bakers formed a union and got a pay rise. Because of the disconnect between their pay and their productivity, this will not automatically lead to unemployment because they will still be paid well below what they produce. Likewise if it is only poor bargaining strength that keeps the cleaners wages low, then a minimum wage rise would not cause unemployment.

The idea that all workers get paid their marginal productivity is a completely unrealistic assumption. Then why is it taught in all textbooks? Because a useful lie is preferable to the uncomfortable truth. By pretending that everyone gets what they produce, no more, no less, economists can pretend that free market is efficient and intervention is unnecessary. In fact the government would only mess up this perfect arrangement. There is no need for minimum wages or trade unions, the market will handle it. If on the other hand, wages are not equal to productivity, then it is all up in the air and all to play for. If power relations are more important than the invisible hand, then leaving it to the free market will not be optimal. If so, then neo-classical economics is built on hollow foundations.

14 thoughts on “Challenging Economics – Marginal Productivity Of Labour”

  1. You argue this well. And, I might add that the way to set a price for a good, like a loaf of bread, is classically done (by economists) by a simple expedient. If the bread does not sell, lower the price. If it sells out easily, raise the price. The right price is found when supply and demand are in balance.

    Makes sense, right? But can this really be done for labor? How many jobs, as a baker, are open, available, and accessible. Obviously a job that offers a higher wage for the same work is desireable, but the amount higher has to be significant enough to make the job change worth the trouble. And how many times can our baker really change jobs? Can he really go out into the “marketplace” and ask for jobs at a pay rate higher than he currently has as part of a scheme to find out what he is really worth? Will he have the time to do so? Will he have the resources to do so? Many do not.

    As you say, fine arguments on paper often don’t translate to reality.

    1. Exactly. One of the major problems with neo-classical economics is that labour is not a good like any other. It is much harder to say it will automatically reach a market clearing equilibrium. It is far more rigid.

  2. The main problem I have with minimum wage laws is that there is no scientific way for the government to set such a rule, and governments are very often bought out by corporate interests. The minimum wage has existed in America for a long time, but it has been stagnant probably because of the American government’s general association with large-scale corporate interests. I much prefer the idea of collective bargaining, because that is a dynamic negotiation process, not a policy. Germany, for example, has collective bargaining instead of minimum wages, and wages in Germany are above the norm and have grown more than in the USA in recent years.

    1. Collective bargaining does have many advantages as it is more geared towards local factors and specificities. I once heard a good argument that conservatives should support unions as when there is no unions the government gets involved in wages. Unions would be more adaptable to local factors than the one size fits all approach. Plus minimum wage only affects about 5% of the workforce whereas unions could affect everyone.

  3. I agree with much of what you say, as far as it goes.

    The problem with any discussion of economics is the assumption that it is a valid scientific discipline when in fact it is a belief system rather like religion.
    In reality it is the science of fraud and exploitation, most of it made up from whole cloth.

    Monetary economies controlled by the private sector are always based upon usury and debt that can never be satisfied and can only and inevitably end in the collapse of the system.

    For-profit economies deny the laws of physics, pretending that those laws are not applicable to economics. A belief from which, ultimately, no good can come.

  4. You need new teachers. Really, that’s not a joke.

    If you don’t read Krugman’s blog and his columns, you might want to start. A recent column is exactly about raising the minimum wage. He has links to economists who have written in favor of it in one of his blog posts. In that column he mentions that the textbook that he wrote also teaches the point you’re arguing against. If your professors aren’t introducing it to you with a lot of caveats, they’re doing you a big disservice. You’ve said before that your professor doesn’t have an obvious ideological bent, but it really sound like he does.

    You need to just try to get good grades in your current classes and move on. Not all economists advocate conservative policies so some of them must have come to different conclusions.

    1. I’m a big fan of Krugman and find his blog really good and had actually come across that post before. I have the feeling that they don’t entirely believe what they are teaching to be entirely true or realistic. Last week I questioned a lecturer on rational expectations and he basically said he didn’t believe, which made me wonder why he was teaching it. It varies a bit with lecturers, generally if we do an indepth study of the minimum wage the problems with the neo-classical views are mentioned, but not in shorter micro classes (which is what far more people do).

      I remember a vote was taken after a debate on the minimum wage (I was the speaker in favour) and it was overwhelming against the wage. I was one of a handful in favour. So the neo-classical view of the minimum wage is getting through

      1. Unfortunately, you probably have something of a self-selecting group when it comes to economics. When I looked at changing fields to something more practical than art, I took classes in several areas including economics. In the end, I decided to go towards computer science because I found the company more congenial – more like artists, so I guess it was a familiar vibe, my comfort zone so to speak. A friend of the family, who had studied economics, advised me against it because, as she put it, “you won’t fit in.”

        When I was in college, I met a guy who was going to a military academy and whose politics were quite far to the left. He told me that he was disturbed by the fact that people who leaned left tended to dismiss the idea of joining the military out of hand. He said he was concerned that if the trend continued we’d have an unhealthy situation with a military far more conservative than the rest of the country. I think he was prescient.

        That’s a long winded way of saying that those students may have had a conservative bias before taking the class.

        You know, when I was in college (university), I slept with a man who afterwards told me that he couldn’t take me seriously as a girlfriend because I was a “commoner” (I’d never heard anyone use that word before and I was shocked.) and he came from an aristocratic family. It was weird since I was only looking for sex and knew nothing about his background. At the time it felt like a gratuitous slap in the face. But the event stuck with me because it made me realize that there really are people who believe class divisions should be maintained. It might have seemed especially weird because, as a good student who never got in trouble, I was used to being the sort of girl families wanted their sons to bring home.

        Anyway, a couple of years ago, I opened the paper to see is name again for the first time in over twenty years. He was advocating austerity in Europe. Could this man possibly be unbiased? Does he have the best interests of the European people at heart? Unless he’s changed his opinions about class, I doubt it. People are more than willing, in my experience, to use economic arguments to justify positions they hold for other reasons.

        We all know, let’s face it, that Keynes’ was one of history’s greatest economic thinkers. There is no good economic argument for austerity. Both theory and practical evidence are against it. So why do they make it? Personally, I think they make these incoherent arguments because, if they said that they think the populace has too much power and they would like to use capitalism to reinstate the rigid class system it undermined two hundred years ago, Greece wouldn’t be the only place with riots.

        You’re very right about one thing, it’s about power.

        1. I’m not sure if economics naturally attracts conservatives (it is an Arts subject after all), it certainly keeps them while pushing others out. Like your military friend, I’m staying in to change it for similar reasons.

          I agree completely with your conclusion. There is no economic reason for austerity, we need Keynesianism.

  5. Not to put too fine a point on it, but I’d like to argue a technical point here hinging on marginal productivity. If we consider diminishing marginal returns (in a mythical perfectly competitive market), the worker would be paid at the point where marginal cost equals marginal revenue. Marginal revenue is represented as a downward sloping curve, so anything above this intersection could accrue to the owner. The worker could be paid at this marginal rate–at the cost of the last unit produced, still leaving room for profits. Am I missing something here?

    1. Well apart from that all of the described features are purely mythical. Also it assumes that all workers get paid separate wages as opposed to one wage for each class of work. It also assumes that marginal benefit can be individualised. I think its best to give up, the marginal productivity of labour can’t be saved.

  6. Your statement that if firms paid wokers for their whole marginal product, they would have no profit clearly reveals you are not familiar with the basic concepts of economics. Firms could still obtain profit from the productivity of capital, from the productivity of entrepreneurial work or from the residual total factor product (TFP). Take a look.

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