Positive Externality

The nature of scarce resources is that everyone wants more than what is available (the very defining premise of economics). There are several ways to “ration” what is available, but one particularly effective rationing mechanism used in all major economies is the concept of a price (or in the case of labor, total compensation of employment).

1. What do you think is the most effective way to decide what the price should be for a product or service? Why? What results would you expect from your proposed mechanism in terms of shortages and surpluses in the market?

2. What do you think is the most effective way to decide what the price for labor should be in a labor market (total compensation)? Why? What results would you expect from your proposed mechanism in terms of shortages and surpluses in the market?

3. If the answer to question #1 differs from that of question #2, what characteristics of the product/service markets vs. labor markets would cause this mechanism to be different? Why?

4. What economic effects would you expect “collective bargaining rights” for government unions to have on the following groups of people: a) existing employees, b) potential employees, c) taxpayers.

5. What economic effects would you expect “collective bargaining rights” for private sector unions (working for a company in perfect competition) to have on the following groups of people: a) existing employees, b) potential employees, c) taxpayers, d) shareholders of the company, and e) consumers of the good or service being produced. Relative to question #4, would you consider these effects to be a) more adverse, b) less adverse, or c) about the same? Why?

6. Many people believe public sector workers fighting for “collective bargaining rights” are “underpaid”. Explain the term “underpaid” in the context of your answer to question #2.

7. Many people believe that the answer to question #4a is “positive” (existing employees get more) and #4c is “negative” (taxpayers pay more). This would suggest a government-imposed wealth transfer from taxpayers in general to existing employees working for the government. Would you consider this wealth transfer a) socially optimal, b) socially suboptimal, or c) doesn’t make a difference. Why?

8. If the answer to question #7 is “a) socially optimal”, what other other mechanisms for achieving the net effect of aforementioned wealth transfer exist within the government’s control, and how do their relative efficiencies/effectivenesses compare? BONUS: If this wealth transfer is socially optimal, what marginal increase to this wealth transfer would cause it to stop being socially optimal (where is the “interior maximum” of the optimization problem).?

It is well understood in economics that cartels are anti-competitive in the sense that they are, by definition, agreements among competitors to fix prices above their market-equilibrium prices.

9. What economic effects would you expect price-fixing cartels to have on the following groups of people: a) employees of the cartel members, b) shareholders of the cartel members, c) consumers of the cartel’s products/services. Taking care not to double-count, would you expect the net social effect to be negative, positive, or zero? Why?

10. Most modern governments have laws against cartels from fixing prices, under the implicit assumption that the answer to question #9 is unambiguously “negative”. Do you agree with these laws against cartels? Why or why not?

12. What economic differences exist between cartels collectively setting prices and labor unions collectively bargaining on total compensation?

13. If included in the answer to any of your questions above includes a claim along the lines of, “people are not products and services” – setting aside for the moment that “labor” is being demanded, not “people”, how is the distinction of what’s being demanded economically relevant to the economic forces at play? Be specific.

14. Does the current budget direction (cutting vs. increasing) have economic relevance to policy question of whether or not “collective bargaining rights” are socially “good” or “bad”? Why or why not?

BONUS QUESTION (Public Choice Economics): Referring back to question #4, how do you expect the *average magnitudes* of the effects to differ amongst the three groups? What might the differences in these magnitudes suggest about incentives for each group to petition the government (protest, lobby, etc.)? Assuming these efforts to petition are successful in making policy changes in favor of each group’s members, are these incentives aligned with what you would consider the socially-optimal policy choice?

I am genuinely interested in responses (in the comments). Inquisitive readers interested in how economists answer these questions and more in almost total unanimity should refer to the article on Labor Unions from the Concise Encyclopedia of Economics. Also, but more broadly, excellent lecture notes on labor market regulation and labor unions from the economist Bryan Caplan.

Perhaps the most interesting area of economics of mine and simultaneously the area in which I have the least formal education is the labor market – specifically the IT labor market. Recently Bruce Webster made some observations about current IT labor strategies that I find to be spot-on: The Wetware Crisis: the Dead Sea Effect. In the article, Bruce describes the current IT labor retention situation much like the dead sea – eventually the true talent leaves and the “residual” is left behind, happy that they have a secure job.

Though I have no statistical evidence, based purely on my experience, I intuitively believe that variance in productivity or “output” in IT – and in software engineering in particular – is significantly higher than most other fields, enough for a standard deviation of orders of magnitudes. I find it entirely reasonable to believe that a talented software engineer can easily produce literally 20x more “output” than a lower-mediocre developer. I don’t think the labor market in IT has entirely captured or adjusted for this fact and is instead stuck representing variance in productivity that is more common in traditional jobs.

It is no wonder then that talented people are leaving large organizations in droves when they are not being properly compensated (salary, work environment, intellectual stimulation, etc.), mostly as a result of managers failing to recognize the important of talent in organizations and the huge variance in applicants’ ability. Bruce writes:

“Large companies tend to lose the really talented IT engineers and hold onto the less talented ones, when they should been actively seeking to do just the opposite. And the effect tends to be self-reinforcing: the worse an IT shop becomes, the harder it is to get really talented and effective IT engineers to join it and the harder it is to retain them if they do.”

Indeed the effect is self-reinforcing because environments not conducive to intellectual stimulation have a snowball effect.

To me the differences in hiring practices between smaller agile startups and larger more “traditional” companies are striking. A few points; but first note that I am using the term “large company” to represent not necessarily a company that is large but a “traditional” company not in-step with what I believe to be effective hiring IT strategy, certainly this would not apply to companies like Microsoft and Google which are of course “large”:

1. Large companies tend to overestimate equality – in many facets, but in particular workforce talent. This leads them to believe this variance in ability is significantly smaller than it is.
2. Large companies with IT departments feel pressured to have compensation variance in IT parallel compensation variance in other departments, even when there is no strictly economic rationale for doing so. Doing this emphasizes the continuum extremes: talented people want to leave for higher-paying opportunities and the lesser-able want to stay and hold on to their high salary (important: high relative to the work output, measured in comparison others in the department).
3. Large companies tend to over-emphasize the “work your way up” approach to salary levels, starting most entry-level applicants at roughly the same rate with yearly increases or bonuses, completely ignorant to actual work output or high differences in starting ability.
4. Large companies are less frequent to acknowledge or point out differences in ability and output at work as doing so is politically incorrect or something that is just “not talked about”.
5. Large companies are for some reason less likely to fire people for reasons of “opportunity cost” – opportunity of hiring better people. Instead people are only fired if they are actively holding an organization back. Firing someone because they are not producing work output per dollar that is on par with either another existing person or another person they could get is an entirely reasonable and economically-justified (in many cases) reason for firing someone, but this just doesn’t happen because of many management and personal reasons (“But I feel bad!”). More on this in the future!

In contrast, many smaller companies and start-ups seem have a much better ability to recognize of this fact: talented people, dollar-for-dollar often simply bring significantly more value to a company, after compensation, than average or lower-quality people. Ultimately this reflects an imbalance in the labor market which I’ll explore later, but you’ll notice that many smaller companies will pay for and try to get younger people based on their talent and experience, not on their age. For many companies there is no “typical” salary – you are paid what you are believed to be worth. These companies actively seek out talented people whereas “large companies” want their applicants to make themselves “worthy” to work there – the completely wrong approach.

Many small companies are reaping the benefits of this labor market imbalance and doing very well. Companies like Google who deliberately seek out high talent and pay their developers extremely well are sucking up talent from other companies not doing so and as a result becoming extremely successful even around a business model that many Wall Street analyzes puzzle over.

By no means do I think what I’ve just described applies to all “large companies” and I use that term very loosely. More accurately, there are companies that “get it” and companies that don’t. The great thing about the free competitive market is that the companies that get it will succeed and those that don’t won’t. In the next few decades companies are going to need to wise up or face major problems with the effectiveness and cost of their IT departments.