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.