Wednesday, February 07, 2007

A mOOm with a View: Guest Post from a Real Economist!

Today I present a special treat-- the very first guest post to appear on My Open Wallet! For those of you who aren't familiar with him, let me introduce mOOm, a frequent commenter on this blog, and writer of Moomin Valley: Personal Finance, Investing and Trading. He is also a professor of economics and an active investor and trader-- exactly the areas of finance I know the least about. So when he alluded to doing an economic analysis based on one of my posts, I jumped at the opportunity, i.e. begged him to write me a guest post. So here it is, folks-- I learned a lot from reading it, and I'm sure you will too-- and his conclusions may surprise you.

What Would Happen in the Labor Market if Everyone Knew Everyone Else’s Salary?

In her post: “Greetings from Davos: Global PF Blogging” Madame X asked lots of really interesting questions about what would happen if everyone fully disclosed everything about their finances to the world. In this post, I’m going to tackle just one of those: “What would happen in if everyone knew everyone else’s salary? Would salaries start climbing due to the openness? Would that lead to inflation? Or would the effect be the opposite?”

The post is pretty long winded – it’s just a kind of stream of consciousness thing - and maybe everything I cover isn’t really necessary to understanding and quite likely makes my point harder to understand. The bottom-line is that employment would fall, low paid workers might see their wages rise but average wages would fall and become more equal.

Like all good economists I’m going to start with an assumption - that all workers are of equal skill and ability. The only point of the assumption is to make the basic idea easier to understand. Once we’ve got that, I’ll relax the assumption. I’ll also assume that there are no unions and that firms bargain with workers by raising their wage offer until a potential worker agrees to accept.

Many of you are probably familiar with the supply and demand model of perfect competition – the best-known model in economics. If this was the way that the labor market worked then all workers at all firms would receive the same salary. Textbook perfect competition is rare, though, in the economic world. One of the few industries that gets anywhere near it is mainstream agriculture where millions of farmers producing standardized crops sell these crops at prices determined on commodity exchanges plus/minus transport costs etc. Anyone can go online and find out what the price of corn is on the Chicago Board of Trade futures market. That’s what a perfectly competitive market looks like. In a perfectly competitive labor market each firm could hire as many workers as it liked at the going market rate without pushing up the market wage rate.

But in the labor market even workers at the same firm don’t know what their colleagues are paid. So clearly the labor market is not perfectly competitive. Instead we have to use a model called “monopsonistic competition”. This is what economists call a situation when there are many (but not too many) employers each of which has some market power in the labor market.
This situation is very similar to industries like retail stores where there are many stores each of which has a little local market power. You as a consumer are not going to go to a store in another city or another state. Even a store in a neighboring suburb is less convenient to go to than one that is closer to you. This allows each store to charge a little extra to its clients than would be the case if they could go to any similar store anywhere in the world. But if they try to charge too much you will desert them for a store in a nearby town even though that is less convenient. Stores and restaurants also differentiate themselves on the basis of products stocked or menu and ambience. These help them develop loyal clienteles that they can then charge more to. Economists call this “monopolistic competition”.

Monopsonistic competitors are buying labor rather than selling meals or groceries. But each develops some market power over the workers who are most enthusiastic about working for them. This allows them to pay a little less than they would have to if workers didn’t care at all where they worked even if it meant a hundred mile commute.

But as long as all salary information is out there in the open they have to pay each worker the same salary. Now what happens when they want to hire extra workers? They have to attract those workers from other firms or pull them away from college or from looking after their children or even retirement. To do that they are going to have to raise the wage they pay. But not only do they have to pay that wage to the new workers they hire, they will also have to raise the wage they pay to their existing workers just like a store that cuts prices to attract more customers has to give those lower prices to its existing loyal customers too. This raises the cost of hiring extra workers above the actual wage paid to those workers. This means that in monopsonistic competition not only do firms pay workers less than they would under perfect competition but they are also more reluctant to hire extra workers and therefore, both wages and employment are lower.

Now what happens when firms can keep the wages they pay each worker secret? They can pay those new workers more than their existing workers – or in general pay workers who are less enthusiastic to work for them (will only come to work there for a higher wage) more and pay workers who are more enthusiastic to work for them less. This makes hiring additional workers
cheaper as the employer doesn’t have to raise the wage of existing workers if they can keep the new hires wages secret. Employment is higher under this “wage discrimination” model. In fact if they could pay each worker an individualized wage they might be able to reach the level of employment that occurs under perfect competition… but earn much higher profits!

This is similar to HSBC’s latest deal to pay 6% only to new deposits from outside the bank on its Online Savings Accounts. Or a pharmaceutical company charging less to the Canadian government than to a US HMO. These are cases of “price discrimination”. They increase profits but get the product to more customers than if they had to charge everyone the same price. Economists say this is more “efficient” than a firm with monopoly power that serves fewer customers at a fixed price.

So, what would happen if everyone, knew everyone else’s salary? Employment would fall as unenthusiastic workers who demand high salaries wouldn’t be hired. Currently low paid workers would see a pay rise. The lower level of employment probably implies that average wages in the economy would be lower. If we add unions or other forms of bargaining to the mix though
things get real complicated…

We can easily model different skill levels by assuming that employers hire units of skill (human capital) rather than hours of work. Then under perfect competition there would be a single national rate for one standardized skill unit. Some workers have more units of skill and get more money than others even without employers having market power. By creating different ranks for different skill levels employers could pay different amounts even if everyone knew everyone else’s salary. But they’d have to pay the same per unit of skill. Under monopsonistic competition and/or wage discrimination different people would receive different amounts for the skill they provide rather than for just the hours provide.

3 comments:

Rich Slick said...

I'm not entirely convinced that most people don't know what other people make to start off with.

Most government job salaries can easily be looked up. Anything from politicians, military, civil service (police, fire, teachers, public administration) are all public record.

In the private sector, public companies list salaries for officers and other employees.

If you are really curious you can look up property tax records, divorce records and other public information fairly easily these days.

Lastly, you have resources like monster.com and various salary survey websites that tell you pretty much what the expected pay is for a particular position.

Anyone who thinks their pay is secret is really fooling themselves.

So my answer to the question: what would happen if everyone knew how much everyone else made: nothing.

mOOm said...

Rich:

Certainly in the public sector that info is out there or pretty accessible. An economist though would ask, if as you say the salary information has no value, why do employers make efforts to try to keep it secret. Are they all just stupid and wasting their time? As economists usually think people are rational and smart until proven otherwise, it should be worth something to those companies to hide the info. Otherwise they wouldn't go through the hassle of doing so.

I guess there must be research somewhere on how much difference this makes. I haven't looked that up. Being in the blogosphere let's me relax and just write what I feel like... but now maybe I'll do some digging.

moneymonk said...

I think if everyone knew everyone else salary is would be complete CHAOS or maybe jealous for that matter.

Currently low paid workers would see a pay rise~ <--- true