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.