Three Ways that Workers Can Be Underpaid

By Donald J. Boudreaux

There are three ways that a worker – call him Joe – can legitimately be said to be underpaid. One way – the way that is identified in modern economics textbooks – is for Joe’s pay (wage plus fringe benefits) to be below the value of his marginal product (“VMP”). If Joe is one of four janitors employed by Acme Inc. and is – like his co-workers – paid $70 per day, Joe is underpaid if his daily contribution to Acme Inc.’s revenues is more than $70. Call this kind of underpayment “Strict Economic Textbook” underpayment.

A second way for Joe to be underpaid is if he’s willing to work at a better job at which an employer offers to employ him, but coercion is used to stop him from taking that better job. Suppose Aunt Esmerelda’s Pizza Emporium offers to employ Joe at $75 per day and Joe accepts. But neighborhood thugs immediately threaten to cage Aunt Esmerelda if she employs Joe. She withdraws her offer of employment. Joe is stuck in his current job. He is here underpaid, even if in his current job his pay is equal to the value of his marginal product. Call this kind of underpayment “Denied the Best Option” underpayment.

A third way for a worker to be underpaid is for that worker to be forcibly or fraudulently prevented from improving his or her marketable skills. Suppose that Joe was, because of his religion or skin color, not allowed to attend college. As a consequence, Joe winds up working as a janitor. Even if Joe’s wage as a janitor equals the value of his marginal product, and even if he is today not prevented from accepting other job offers, Joe can legitimately be said to be underpaid.

In the current period Joe is not technically underpaid. That is, Joe isn’t underpaid according to the strict economic meaning of the term: his pay equals the value of his marginal product, and employers are allowed freely to compete for his services. But stepping back to examine the processes that operated over time we see that Joe, by going to college, would have increased his skills but was forcibly stopped from doing so. As a result Joe is stuck today with fewer skills and, thus, with lower-paying employment. Joe is here, in a real sense, underpaid despite the fact that today’s labor market is operating just as it should. Call this kind of underpayment “Kept Less Skilled” underpayment.

Labor-Market Competition is a Boon to Workers

If markets are free, the first kind of underpayment – “Strict Economic Textbook” underpayment – is of little practical importance, even if it does exist in comparison to a textbook-perfect competitive market. If Joe is paid much less than the value of his marginal product, some other firm can likely gain by bidding Joe away from his current employer. Joe’s pay is thus bid up closer to the value of his marginal product. Such competitive bidding for Joe’s services continues until his pay is not much lower than the value of his marginal product.

The second kind of underpayment – “Denied the Best Option” underpayment – is nonexistent in competitive markets. If Joe may take whatever job is offered to him, and do so on whatever terms he and the employer find mutually agreeable, then the job that Joe takes will be one that, by his own lights, is best for him.

Importantly, Joe might choose a job that pays less money than another job that is offered to him. Joe will make such a choice if he finds the non-wage aspects of the lower-paying job to be sufficiently better than the non-wage aspects of the higher-paying job. I myself, in 1992, turned down a much higher-paying job at a DC law firm in order to take a faculty position at Clemson University. The non-wage amenities of a university faculty position were – and are – to me worth more than the significantly greater amount of money that I would earn by toiling as an attorney. And so it would be absurd to compare my academic salary to that of a big-city lawyer and conclude that I’m underpaid – or that the attorney is overpaid. I’m not and she’s not. The fact that I would love to have my academic job but also get paid a salary equal to that of a big-city attorney is irrelevant.

Also, if Joe is free to accept whatever job offers he wishes, it’s no longer clear that Joe is underpaid even if in his current job his pay is less than the value of his marginal product.

Compared to most textbook models, reality often is (as economists say) “lumpy.” For example, worker productivity might change not in minuscule increments but in lumps. If Joe’s current job pays $70 per day, his next-best option might be a job paying, not $69.99 per day but, say, $64 per day. Is Joe underpaid if in his current job he’s paid $70 even though the value of his marginal product is $75? Strict economic theory answers “Yes. Joe is underpaid by $5 per day.” But what normative conclusion to draw from this textbook ‘fact?’ If Joe’s next best option is an equivalent job that pays $64 per day, it’s difficult to argue that Joe is harmed by his current employer given that, were this employer not to exist, Joe would have to settle for a job that pays $6 per day less.

Furthermore, while “lumpiness” might cause a slight amount of “Strict Economic Textbook” underpayment to persist in reality, competition – if not obstructed – ensures that this underpayment will be small.

The Baneful Consequences of Restrictions Imposed by Government

The overwhelming source of underpayment is government. Government often prevents people from accepting jobs that are offered to them and that they would otherwise take. An example in the past of “Denied the Best Option” and “Kept Less Skilled” sources of underpayment was government preventing certain employers from hiring blacks. Black workers were thus stuck in jobs that were not their first choice and that did not enable them to enhance their skills as much as otherwise.

Minimum-wage legislation today has the same doleful effect. By preventing workers from accepting jobs at wages below state-dictated minima, many workers are forced into the $0 pay ‘occupation’ of involuntary leisure, or into worse underground-economy employment. These workers are denied their best options.

Further, by keeping many unskilled workers today from being employed, minimum wages prevent people from gaining skills that these people would otherwise have gained. And so the unskilled 20-year-old who finally gets her first job might well be paid the full value of her marginal product. But because her skills would have been much higher had she not for years been priced out of the labor market by minimum-wage legislation, this worker can reasonably be said to be underpaid.

Other sources of “Denied the Best Option” and “Kept Less Skilled” underpayment are occupational-licensing restrictions and labor-union protections, each of which artificially block certain workers from taking their preferred employment options and, in consequence, often keeps them from developing marketable skills that would cause their future pay to rise.

The bottom line is clear: government is the largest cause of worker underpayment and open, free markets for labor are the best protection against any kind of underpayment.

Source: AIER.org