Wednesday, January 13, 2016

The Lemon Problem as Social Policy

I frequently see assertions that income inequality has risen because workers have less bargaining power than they used to, and the blame for this shift is placed on the decline of private sector unions.  It is good to see some proponents of this assertion beginning to acknowledge that this is not a matter of income distribution between labor vs. capital, but rather a matter of distribution within labor and capital.  The proportion of domestic income to firms, creditors, and proprietors has traced a longstanding flat trend, and as Song, Price, Guvenen, and Bloom (pdf) have found, intra-firm wage inequality appears to have been stable for decades.  I think Mark Thoma seems to recognize this issue here, but one might be forgiven for not realizing that:
Finally, and importantly, workers need to be able to capture the gains from increases in their productivity. Over the last several decades wages have managed to rise with the inflation rate, but they have not risen with productivity.
I believe this is mainly due to differences in bargaining power. When there is an increase in productivity, the gains are up for grabs. Will they go to the owners or the workers? When unions were strong, workers were able to bargain effectively to claim a large fraction of these gains for themselves. But as unions have faded, bargaining power has become increasingly one-sided, and those gains have gone mostly to those at the top of the income distribution.
He doesn't say that gains have gone to firms.  He says they have gone to the "top of the income distribution".  So I think he must be hedging about this issue, but the two sentences before that create a different implication.

I think it is interesting to think about this issue, because, really, what we have in labor markets is a "Lemon Problem".  There are a lot of information asymmetry problems that employers have to deal with in hiring, managing, and promoting workers.  I think we fairly universally recognize that within any given firm, the correlation between individual salaries and individual value added is much less than one.

What if the new trend of some firms with higher profits and higher intra-firm wages than other firms is a sign that some industries have solved some of the lemon problem?  If they have solved the lemon problem, they are able to more precisely match workers to their productivity.  The improved productivity and better worker-job matching would lift firm profits and worker wages.  In labor markets characterized by this shift, the distribution of incomes would steepen, just as a regression line steepens as residual errors are reduced.  Could the firms with lower profits be firms in sectors that haven't solved the lemon problem?

In a way, unions work by reinforcing the lemon problem.  They provide security for workers by shifting their employment risks to predictable elements - away from discretionary, performance-based judgments and toward credentials and seniority.  Other sorts of legislative labor protections also reinforce the lemon problem, by making dismissals more difficult, etc.

But, if we think of the classic "lemon problem" market - used cars - these sorts of solutions would seem strange.  I don't think anybody has ever suggested that the used car lemon problem should be solved by giving used car dealers more negotiating power.  I don't think anyone has ever suggested that we should have laws preventing car dealers from offering return policies.

As you might have guessed if you are an IW regular, I think this is related to housing.  As I have argued, the cities with very high average incomes and very high income inequality tend to be cities with constrained and expensive housing.  There are industries in places like New York City, San Jose and San Francisco which seem to find great value in having a dense population of creative and innovative workers.  That factor is the thing that draws workers into those markets.  I think if those cities solved the housing supply problem, we would see a reduction in those high profits and high wages, because with the influx of more firms and workers to compete, the excess would accrue to consumer surplus.  But, in the meantime, it seems pretty clear that there is a concentration of the firms that are archetypal high profit/high wage firms within these high-rent cities, and it is easy to imagine how the lemon problem plays into these trends.

My impression of Silicon Valley is that there is a culture of collaberation and of project hopping.  The geographic density of the labor pool is important there, because it means creative tech workers take on fewer risks and frictions in matching their value to jobs.  I don't know.  Maybe the economic rents created by the housing supply problem help to make this culture flourish.  Maybe, without the cushion of economic rents provided by the lack of access, firms would be more guarded.

Markets are always searching for solutions to this problem.  The signaling element of education is an important part of this process.  And, solutions to the lemon problem can add economic pressures to vulnerable workers.  Because it is common knowledge that I can't hit 3-pointers like Stephen Curry, I have little chance of even getting a small contract from the Golden State Warriors.  You could say that, as a vulnerable worker, I have less negotiating power than Stephen.  That wouldn't be a very useful way of understanding my plight.  And, it certainly wouldn't be in anyone's interest to add information asymmetries that would make it difficult to find out who was the better basketball player.  It should shock us when policies that are essentially doing that are the best ideas some people have for pulling up low incomes.

I have seen complaints about the difficulty some workers were having in finding new work after they had been receiving long term unemployment insurance.  In that case, a social safety net policy may have alleviated some information asymmetries.  The extended support incentivized some workers to hold out for better options.  This was one of the policy's explicit goals.  But, in the end, the extended length of unemployment may have served as a piece of information valuable enough (even if imperfect) to counter the benefit of a patient job search.  I suppose we can just blame employers for using the information to try to find the best worker-job matches within their firms.  Moral demands that contradict natural and understandable human relations tend to lose over time, but they can do a bit of damage on their way there.

If, as a first step, we all simply approached employer-employee dilemmas as analogous to a trip to the used car lot, maybe we would approach them with the sort of empathy that leads to reasonable and judicious solutions.

Maybe technological progress and a more dynamic labor market naturally lead to more wage inequality.  In that case, we need solutions that don't undermine that dynamism.  But, as a first step, I sure would like to see the cost of living in those dynamic cities come down through housing expansion.  Maybe this is all a misdirection that comes from limited access.  Maybe in an economy with free-flowing capital, consumer surplus is a significant mitigating force to improvements in the matching process of laborers and jobs.  Maybe in an open economy, we wouldn't even have noticed that this would have been a problem.


  1. As long as you think that capital is good, you can model anything you want, Kevin. But capital is not good, and so unions were formed. Now capital has broken unions and we see backbone companies like Disney paying 9 dollars an hour for home jobs that offer no benefits. How much do ya think labor will contribute to GDP when jobs like that are starting to abound? Capital, like Disney, is greedy, and doesn't fit the model. Capital pays what desperate workers seek to make to keep from living on the street.

    This is why I don't endorse MMers, because they are right about some things, but come from places where the invisible hand of self interest is held in high regard. But I gave you all kudos here:

  2. TravisV here.

    Off-topic, is there a good article out there detailing the exit of dovish FOMC voting members and entrance of hawkish FOMC voting members at the end of 2015 / beginning of 2016?

    1. Nothing that I have saved. Lining up for a real problem, aren't we?

    2. Yes we are. The Fed should be buying dirt now. But it is still against the law for our Fed to buy non financial assets, right? Ordinarily I would find doing so to be repulsive, but we are falling off a cliff here, and others have warned of that.

  3. Thoughtful blogging.

    Build more housing! Print more money!

    And my pet idea: decriminalize push-cart vending.

    At first, push-cart vending might seem like a small issue. But think about it. Every city restricts retail sales to a fixed amount to physical space. Retail space becomes expensive.

    Additionally, I do not support the minimum wage. But, if a typical worker could say "take it this job and shove it" and start his own soup kitchen on wheels, I might feel better about my position.

    I would also feel better about "no minimum wage" if it was not the explicit policy of the central bank to "fight inflation" by keeping unemployment above 1 in 20 workers, except when even higher rates of unemployment are sought.

  4. That's an interesting way to reduce barriers to entry. Makes me think of the character of Bubbles from The Wire. Anyway, it would be interesting to see how restaurant prices in cities with more lax regulation on street vending or food trucks compare to those with stricter regulation.

    I would argue that there are a whole host of industries where similar sort of impediments build be removed to drive down prices. Why not let people offer haircuts on a street corner (or in their homes, perhaps)? There are a lot of markets to which you could apply the logic of Uber were it not for things like licensing requirements.

    Of course, to open up those markets you have to get rid of regulations that protect big businesses' monopolies/oligopolies and (in the very short run) their employees, and on this matter, the so-called money illusion is a big issue. It doesn't seem to compute with most people that a 50% decline in real prices is the same as a 100% increase in real income. This I think is why so many voters are more willing to support policies that see wages go up but prices go up more than policies that see wages go down but prices go down even more.

  5. Mark--
    Agreed---wherever possible, increase potential competition.

    Ground-floor retail values would sink...

    The legal profession is just awful....