Category Archives: Labor

“Bonus Culture: Competitive Pay, Screening and Multitasking,” R. Benabou & J. Tirole (2014)

Empirically, bonus pay as a component of overall renumeration has become more common over time, especially in highly competitive industries which involve high levels of human capital; think of something like management of Fortune 500 firms, where the managers now have their salary determined globally rather than locally. This doesn’t strike most economists as a bad thing at first glance: as long as we are measuring productivity correctly, workers who are compensated based on their actual output will both exert the right amount of effort and have the incentive to improve their human capital.

In an intriguing new theoretical paper, however, Benabou and Tirole point out that many jobs involve multitasking, where workers can take hard-to-measure actions for intrinsic reasons (e.g., I put effort into teaching because I intrinsically care, not because academic promotion really hinges on being a good teacher) or take easy-to-measure actions for which there might be some kind of bonus pay. Many jobs also involve screening: I don’t know who is high quality and who is low quality, and although I would optimally pay people a bonus exactly equal to their cost of effort, I am unable to do so since I don’t know what that cost is. Multitasking and worker screening interact among competitive firms in a really interesting way, since how other firms incentivize their workers affects how workers will respond to my contract offers. Benabou and Tirole show that this interaction means that more competition in a sector, especially when there is a big gap between the quality of different workers, can actually harm social welfare even in the absence of any other sort of externality.

Here is the intuition. For multitasking reasons, when different things workers can do are substitutes, I don’t want to give big bonus payments for the observable output, since if I do the worker will put in too little effort on the intrinsically valuable task: if you pay a trader big bonuses for financial returns, she will not put as much effort into ensuring all the laws and regulations are followed. If there are other finance firms, though, they will make it known that, hey, we pay huge bonuses for high returns. As a result, workers will sort, with all of the high quality traders will move to the high bonus firm, leaving only the low quality traders at the firm with low bonuses. Bonuses are used not only to motivate workers, but also to differentially attract high quality workers when quality is otherwise tough to observe. There is a tradeoff, then: you can either have only low productivity workers but get the balance between hard-to-measure tasks and easy-to-measure tasks right, or you can retain some high quality workers with large bonuses that make those workers exert too little effort on hard-to-measure tasks. When the latter is more profitable, all firms inefficiently begin offering large, effort-distorting bonuses, something they wouldn’t do if they didn’t have to compete for workers.

How can we fix things? One easy method is with a bonus cap: if the bonus is capped at the monopsony optimal bonus, then no one can try to screen high quality workers away from other firms with a higher bonus. This isn’t as good as it sounds, however, because there are other ways to screen high quality workers (such as offering lower clawbacks if things go wrong) which introduce even worse distortions, hence bonus caps may simply cause less efficient methods to perform the same screening and same overincentivization of the easy-to-measure output.

When the individual rationality or incentive compatibility constraints in a mechanism design problem are determined in equilibrium, based on the mechanisms chosen by other firms, we sometimes called this a “competing mechanism”. It seems to me that there are quite a number of open questions concerning how to make these sorts of problems tractable; a talented young theorist looking for a fun summer project might find it profitable to investigate this as-yet small literature.

Beyond the theoretical result on screening plus multitasking, Tirole and Benabou also show that their results hold for market competition more general than just perfect competition versus monopsony. They do this through a generalized version of the Hotelling line which appears to have some nice analytic properties, at least compared to the usual search-theoretic models which you might want to use when discussing imperfect labor market competition.

Final copy (RePEc IDEAS version), forthcoming in the JPE.

“The Rents from Sugar and Coercive Institutions: Removing the Sugar Coating,” C. Dippel, A. Greif & D. Trefler (2014)

Today, I’ve got two posts about some new work by Christian Dippel, an economic historian at UCLA Anderson who is doing some very interesting theoretically-informed history; no surprise to see Greif and Trefler as coauthors on this paper, as they are both prominent proponents of this analytical style.

The authors consider the following puzzle: sugar prices absolutely collapse during the mid and late 1800s, largely because of the rise of beet sugar. And yet, wages in the sugar-dominant British colonies do not appear to have fallen. This is odd, since all of our main theories of trade suggest that when an export price falls, the price of factors used to produce that export also fall (this is less obvious than just marginal product falling, but still true).

The economics seem straightforward enough, so what explains the empirical result? Well, the period in question is right after the end of slavery in the British Empire. There were lots of ways in which the politically powerful could use legal or extralegal means to keep wages from rising to marginal product. Suresh Naidu, a favorite of this blog, has a number of papers on labor coercion everywhere from the UK in the era of Master and Servant Law, to the US South post-reconstruction, to the Middle East today; actually, I understand he is writing a book on the subject which, if there is any justice, has a good shot at being the next Pikettyesque mainstream hit. Dippel et al quote a British writer in the 1850s on the Caribbean colonies: “we have had a mass of colonial legislation, all dictated by the most short-sighted but intense and disgraceful selfishness, endeavouring to restrict free labour by interfering with wages, by unjust taxation, by unjust restrictions, by oppressive and unequal laws respecting contracts, by the denial of security of [land] tenure, and by impeding the sale of land.” In particular, wages rose rapidly right after slavery ended in 1838, but those gains were clawed back by the end of 1840s due to “tenancy-at-will laws” (which let employers seize some types of property if workers left), trespass and land use laws to restrict freeholding on abandoned estates and Crown land, and emigration restrictions.

What does labor coercion have to do with wages staying high as sugar prices collapse? The authors write a nice general equilibrium model. Englishmen choose whether to move to the colonies (in which case they get some decent land) or to stay in England at the outside wage. Workers in the Caribbean can either take a wage working sugar which depends on bargaining power, or they can go work marginal freehold land. Labor coercion rules limit the ability of those workers to work some land, so the outside option of leaving the sugar plantation is worse the more coercive institutions are. Governments maximize a weighted combination of Englishmen and local wages, choosing the coerciveness of institutions. The weight on Englishmen wages is higher the more important sugar exports and their enormous rents are to the local economy. In partial equilibrium, then, if the price of sugar falls exogenously, the wages of workers on sugar plantations falls (as their MP goes down), the number of locals willing to work sugar falls, hence the number of Englishman willing to stay falls (as their profit goes down). With few plantations, sugar rents become less important, labor coercion falls, opening up more marginal land for freeholders, which causes even more workers to leave sugar plantations and improves wages for those workers. However, if sugar is very important, the government places a lot of weight on planter income in the social welfare function, hence responds to a fall in sugar prices by increasing labor coercion, lowering the outside option of workers, keeping them on the sugar plantations, where they earn lower wages than before for the usual economic reasons. That is, if sugar is really important, coercive institutions will be retained, the economic structure will be largely unchanged in response to a fall in world sugar prices, and hence wages will fall, but if sugar is only of marginal importance, a fall in sugar prices leads the politically powerful to leave, lowering the political strength of the planter class, thus causing coercive labor institutions to decline, allowing workers to reallocate such that wages approach marginal product; since the MP of options other than sugar may be higher than the wage paid to sugar workers, this reallocation caused by the decline of sugar prices can cause wages in the colony to increase.

The British, being British, kept very detailed records of things like incarceration rates, wages, crop exports, and the like, and the authors find a good deal of empirical evidence for the mechanism just described. To assuage worries about the endogeneity of planter power, they even get a subject expert to construct a measure of geographic suitability for sugar in each of 14 British Caribbean colonies, and proxies for planter power with the suitability of marginal land for sugar production. Interesting work all around.

What should we take from this? That legal and extralegal means can be used to keep factor rents from approaching their perfect competition outcome: well, that is something essentially every classical economist from Smith to Marx has described. The interesting work here is the endogeneity of factor coercion. There is still some debate about much we actually know about whether these endogenous institutions (or, even more so, the persistence of institutions) have first-order economic effects; see a recent series of posts by Dietz Vollrath for a skeptical view. I find this paper by Dippel et al, as well as recent work by Naidu and Hornbeck, are the cleanest examples of how exogenous shocks affect institutions, and how those institutions then affect economic outcomes of great importance.

December 2014 working paper (no RePEc IDEAS version)

Labor Unions and the Rust Belt

I’ve got two nice papers for you today, both exploring a really vexing question: why is it that union-heavy regions of the US have fared so disastrously over the past few decades? In principle, it shouldn’t matter: absent any frictions, a rational union and a profit-maximizing employer ought both desire to take whatever actions generate the most total surplus for the firm, with union power simply affecting how those rents are shared between management, labor and owners. Nonetheless, we notice empirically a couple of particularly odd facts. First, especially in the US, union-dominated firms tend to limit adoption of new, productivity-enhancing technology; the late adoption of the radial tire among U.S. firms is a nice example. Second, unions often negotiate not only about wages but about “work rules”, insisting upon conditions like inflexible employee roles. A great example here is a California longshoremen contract which insisted upon a crew whose sole job was to stand and watch while another crew did the job. Note that preference for leisure can’t explain this, since surely taking that leisure at home rather than standing around the worksite would be preferable for the employees!

What, then, might drive unions to push so hard for seemingly “irrational” contract terms, and how might union bargaining power under various informational frictions or limited commitment affect the dynamic productivity of firms? “Competition, Work Rules and Productivity” by the BEA’s Benjamin Bridgman discusses the first issue, and a new NBER working paper, “Competitive Pressure and the Decline of the Rust Belt: A Macroeconomic Analysis” by Alder, Lagakos and Ohanian covers the second; let’s examine these in turn.

First, work rules. Let a union care first about keeping all members employed, and about keeping wage as high as possible given full employment. Assume that the union cannot negotiate the price at which products are sold. Abstractly, work rules are most like a fixed cost that is a complete waste: no matter how much we produce, we have to incur some bureaucratic cost of guys standing around and the like. Firms will set marginal revenue equal to marginal cost when deciding how much to produce, and at what price that production should be sold. Why would the union like these wasteful costs?

Let firm output given n workers just be n-F, where n is the number of employees, and F is how many of them are essentially doing nothing because of work rules. The firm chooses price p and the number of employees n given demand D(p) and wage w to maximize p*D(p)-w*n, subject to total production being feasible D(p)=n-F. Note that, as long as total firm profits under optimal pricing exceed F, the firm stays in business and its pricing decision, letting marginal revenue equal marginal cost, is unaffected by F. That is, the optimal production quantity does not depend on F. However, the total amount of employment does depend on F, since to produce quantity D(p) you need to employ n-F workers. Hence there is a tradeoff if the union only negotiates wages: to employ more people, you need a lower wage, but using wasteful work rules, employment can be kept high even when wages are raised. Note also that F is limited by the total rents earned by the firm, since if work rules are particularly onerous, firms that are barely breaking even without work rules will simply shut down. Hence in more competitive industries (formally, when demand is less elastic), work rules are less likely to imposed by unions. Bridgman also notes that if firms can choose technology (output is An-F, where A is the level of technology), then unions will resist new technology unless they can impose more onerous work rules, since more productive technology lowers the number of employees needed to produce a given amount of output.

This is a nice result. Note that the work rule requirements have nothing to do with employees not wanting to work hard, since work rules in the above model are a pure waste and generate no additional leisure time for workers. Of course, this result really hinges on limiting what unions can bargain over: if they can select the level of output, or can impose the level of employment directly, or can permit lump-sum transfers from management to labor, then unionized firms will produce at the same productivity at non-unionized firms. Information frictions, among other worries, might be a reason why we don’t see these types of contracts at some unionized firms. With this caveat in mind, let’s turn to the experience of the Rust Belt.

The U.S. Rust Belt, roughly made up of states surrounding the Great Lakes, saw a precipitous decline from the 1950s to today. Alder et al present the following stylized facts: the share of manufacturing employment in the U.S. located in the Rust Belt fell from the 1950s to the mid-1980s, there was a large wage gap between Rust Belt and other U.S. manufacturing workers during this period, Rust Belt firms were less likely to adopt new innovations, and labor productivity growth in Rust Belt states was lower than the U.S. average. After the mid-1980s, Rust Belt manufacturing firms begin to look a lot more like manufacturing firms in the rest of the U.S.: the wage gap is essentially gone, the employment share stabilizes, strikes become much less common, and productivity growth is similar. What happened?

In a nice little model, the authors point out that output competition (do I have lots of market power?) and labor market bargaining power (are my workers powerful enough to extract a lot of my rents?) interact in an interesting way when firms invest in productivity-increasing technology and when unions cannot commit to avoid a hold-up problem by striking for a better deal after the technology investment cost is sunk. Without commitment, stronger unions will optimally bargain away some of the additional rents created by adopting an innovation, hence unions function as a type of tax on innovation. With sustained market power, firms have an ambiguous incentive to adopt new technology – on the one hand, they already have a lot of market power and hence better technology will not accrue too many more sales, but on the other hand, having market power in the future makes investments today more valuable. Calibrating the model with reasonable parameters for market power, union strength, and various elasticities, the authors find that roughly 2/3 of the decline in the Rust Belt’s manufacturing share can be explained by strong unions and little output market competition decreasing the incentive to invest in upgrading technology. After the 1980s, declining union power and more foreign competition limited both disincentives and the Rust Belt saw little further decline.

Note again that unions and firms rationally took actions that lowered the total surplus generated in their industry, and that if the union could have committed not to hold up the firm after an innovation was adopted, optimal technology adoption would have been restored. Alder et al cite some interesting quotes from union heads suggesting that the confrontational nature of U.S. management-union relations led to a belief that management figures out profits, and unions figure out to secure part of that profit for their members. Both papers discussed here show that this type of division, by limiting the nature of bargains which can be struck, can have calamitous effects for both workers and firms.

Bridgman’s latest working paper version is here (RePEc IDEAS page); the latest version of Adler, Lagakos and Ohanian is here (RePEc IDEAS). David Lagakos in particular has a very nice set of recent papers about why services and agriculture tend to have such low productivity, particularly in the developing world; despite his macro background, I think he might be a closet microeconomist!

On Gary Becker

Gary Becker, as you must surely know by now, has passed away. This is an incredible string of bad luck for the University of Chicago. With Coase and Fogel having passed recently, and Director, Stigler and Friedman dying a number of years ago, perhaps Lucas and Heckman are the only remaining giants from Chicago’s Golden Age.

Becker is of course known for using economic methods – by which I mean constrained rational choice – to expand economics beyond questions of pure wealth and prices to question of interest to social science at large. But this contribution is too broad, and he was certainly not the only one pushing such an expansion; the Chicago Law School clearly was doing the same. For an economist, Becker’s principal contribution can be summarized very simply: individuals and households are producers as well as consumers, and rational decisions in production are as interesting to analyze as rational decisions in consumption. As firms must purchase capital to realize their productive potential, humans much purchase human capital to improve their own possible utilities. As firms take actions today which alter constraints tomorrow, so do humans. These may seem to be trite statements, but that are absolutely not: human capital, and dynamic optimization of fixed preferences, offer a radical framework for understanding everything from topics close to Becker’s heart, like educational differences across cultures or the nature of addiction, to the great questions of economics like how the world was able to break free from the dreadful Malthusian constraint.

Today, the fact that labor can augment itself with education is taken for granted, which is a huge shift in how economists think about production. Becker, in his Nobel Prize speech: “Human capital is so uncontroversial nowadays that it may be difficult to appreciate the hostility in the 1950s and 1960s toward the approach that went with the term. The very concept of human capital was alleged to be demeaning because it treated people as machines. To approach schooling as an investment rather than a cultural experience was considered unfeeling and extremely narrow. As a result, I hesitated a long time before deciding to call my book Human Capital, and hedged the risk by using a long subtitle. Only gradually did economists, let alone others, accept the concept of human capital as a valuable tool in the analysis of various economic and social issues.”

What do we gain by considering the problem of human capital investment within the household? A huge amount! By using human capital along with economic concepts like “equilibrium” and “private information about types”, we can answer questions like the following. Does racial discrimination wholly reflect differences in tastes? (No – because of statistical discrimination, underinvestment in human capital by groups that suffer discrimination can be self-fulfilling, and, as in Becker’s original discrimination work, different types of industrial organization magnify or ameliorate tastes for discrimination in different ways.) Is the difference between men and women in traditional labor roles a biological matter? (Not necessarily – with gains to specialization, even very small biological differences can generate very large behavioral differences.) What explains many of the strange features of labor markets, such as jobs with long tenure, firm boundaries, etc.? (Firm-specific human capital requires investment, and following that investment there can be scope for hold-up in a world without complete contracts.) The parenthetical explanations in this paragraph require completely different policy responses from previous, more naive explanations of the phenomena at play.

Personally, I find human capital most interesting in understanding the Malthusian world. Malthus conjectured the following: as productivity improved for some reason, excess food will appear. With excess food, people will have more children and population will grow, necessitating even more food. To generate more food, people will begin farming marginal land, until we wind up with precisely the living standards per capita that prevailed before the productivity improvement. We know, by looking out our windows, that the world in 2014 has broken free from Malthus’ dire calculus. But how? The critical factors must be that as productivity improves, population does not grow, or else grows slower than the continued endogenous increases in productivity. Why might that be? The quantity-quality tradeoff. A productivity improvement generates surplus, leading to demand for non-agricultural goods. Increased human capital generates more productivity on those goods. Parents have fewer kids but invest more heavily in their human capital so that they can work in the new sector. Such substitution is only partial, so in order to get wealthy, we need a big initial productivity improvement to generate demand for the goods in the new sector. And thus Malthus is defeated by knowledge.

Finally, a brief word on the origin of human capital. The idea that people take deliberate and costly actions to improve their productivity, and that formal study of this object may be useful, is modern: Mincer and Schultz in the 1950s, and then Becker with his 1962 article and famous 1964 book. That said, economists (to the chagrin of some other social scientists!) have treated humans as a type of capital for much longer. A fascinating 1966 JPE [gated] traces this early history. Petty, Smith, Senior, Mill, von Thunen: they all thought an accounting of national wealth required accounting for the productive value of the people within the nation, and 19th century economists frequently mention that parents invest in their children. These early economists made such claims knowing they were controversial; Walras clarifies that in pure theory “it is proper to abstract completely from considerations of justice and practical expediency” and to regard human beings “exclusively from the point of view of value in exchange.” That is, don’t think we are imagining humans as being nothing other than machines for production; rather, human capital is just a useful concept when discussing topics like national wealth. Becker, unlike the caricature where he is the arch-neoliberal, was absolutely not the first to “dehumanize” people by rationalizing decisions like marriage or education in a cost-benefit framework; rather, he is great because he was the first to show how powerful an analytical concept such dehumanization could be!

Dale Mortensen as Micro Theorist

Northwestern’s sole Nobel Laureate in economics, Dale Mortensen, passed overnight; he remained active as a teacher and researcher over the past few years, though I’d be hearing word through the grapevine about his declining health over the past few months. Surely everyone knows Mortensen the macroeconomist for his work on search models in the labor market. There is something odd here, though: Northwestern has really never been known as a hotbed of labor research. To the extent that researchers rely on their coworkers to generate and work through ideas, how exactly did Mortensen became such a productive and influential researcher?

Here’s an interpretation: Mortensen’s critical contribution to economics is as the vector by which important ideas in micro theory entered real world macro; his first well-known paper is literally published in a 1970 book called “Microeconomic Foundations of Employment and Inflation Theory.” Mortensen had the good fortune to be a labor economist working in the 1970s and 1980s at a school with a frankly incredible collection of microeconomic theorists; during those two decades, Myerson, Milgrom, Loury, Schwartz, Kamien, Judd, Matt Jackson, Kalai, Wolinsky, Satterthwaite, Reinganum and many others were associated with Northwestern. And this was a rare condition! Game theory is everywhere today, and pioneers in that field (von Neumann, Nash, Blackwell, etc.) were active in the middle of the century. Nonetheless, by the late 1970s, game theory in the social sciences was close to dead. Paul Samuelson, the great theorist, wrote essentially nothing using game theory between the early 1950s and the 1990s. Quickly scanning the American Economic Review from 1970-1974, I find, at best, one article per year that can be called game-theoretic.

What is the link between Mortensen’s work and developments in microeconomic theory? The essential labor market insight of search models (an insight which predates Mortensen) is that the number of hires and layoffs is substantial even in the depth of a recession. That is, the rise in the unemployment rate cannot simply be because the marginal revenue of the potential workers is always less than the cost, since huge numbers of the unemployed are hired during recessions (as others are fired). Therefore, a model which explains changes in churn rather than changes in the aggregate rate seems qualitatively important if we are to develop policies to address unemployment. This suggests that there might be some use in a model where workers and firms search for each other, perhaps with costs or other frictions. Early models along this line by Mortensen and others were generally one-sided and hence non-strategic: they had the flavor of optimal stopping problems.

Unfortunately, Diamond in a 1971 JET pointed out that Nash equilibrium in two-sided search leads to a conclusion that all workers are paid their reservation wage: all employers pay the reservation wage, workers believe this to be true hence do not engage in costly search to switch jobs, hence the belief is accurate and nobody can profitably deviate. Getting around the “Diamond Paradox” involved enriching the model of who searches when and the extent to which old offers can be recovered; Mortensen’s work with Burdett is a nice example. One also might ask whether laissez faire search is efficient or not: given the contemporaneous work of micro theorists like Glenn Loury on mathematically similar problems like the patent race, you might imagine that efficient search is unlikely.

Beyond the efficiency of matches themselves is the question of how to split surplus. Consider a labor market. In the absence of search frictions, Shapley (first with Gale, later with Shubik) had shown in the 1960s and early 1970s the existence of stable two-sided matches even when “wages” are included. It turns out these stable matches are tightly linked to the cooperative idea of a core. But what if this matching is dynamic? Firms and workers meet with some probability over time. A match generates surplus. Who gets this surplus? Surely you might imagine that the firm should have to pay a higher wage (more of the surplus) to workers who expect to get good future offers if they do not accept the job today. Now we have something that sounds familiar from non-cooperative game theory: wage is based on the endogenous outside options of the two parties. It turns out that noncooperative game theory had very little to say about bargaining until Rubinstein’s famous bargaining game in 1982 and the powerful extensions by Wolinsky and his coauthors. Mortensen’s dynamic search models were a natural fit for those theoretic developments.

I imagine that when people hear “microfoundations”, they have in mind esoteric calibrated rational expectations models. But microfoundations in the style of Mortensen’s work is much more straightforward: we simply cannot understand even the qualitative nature of counterfactual policy in the absence of models that account for strategic behavior. And thus the role for even high micro theory, which investigates the nature of uniqueness of strategic outcomes (game theory) and the potential for a planner to improve welfare through alternative rules (mechanism design). Powerful tools indeed, and well used by Mortensen.

“The Economic Benefits of Pharmaceutical Innovations: The Case of Cox-2 Inhibitors,” C. Garthwaite (2012)

Cost-benefit analysis and comparative effectiveness are the big buzzwords in medical policy these days. If we are going to see 5% annual real per-capita increases in medical spending, we better be getting something for all that effort. The usual way to study cost effectiveness is with QALYs, Quality-Adjusted Life Years. The idea is that a medicine which makes you live longer, with less pain, is worth more, and we can use alternative sources (such as willingness to accept jobs with higher injury risk) to get numerical values on each component of the QALY.

But medicine has other economic effects, as Craig Garthwaite (from here at Kellogg) reminds us in a recent paper of his. One major impact is through the labor market: the disabled or those with chronic pain choose to work less. Garthwaite considers the case of Vioxx. Vioxx was a very effective remedy for long-term pain, which (it was thought) could be used without the gastrointestinal side effects of ibuprofen or naproxen. It rapidly become very widely prescribed. However, evidence began to accumulate which suggested that Vioxx also caused serious heart problems, and the pill was taken off the market in 2004. Alternative joint pain medications for long term use weren’t really comparable (though, having taken naproxen briefly for a joint injury, I assure you it is basically a miracle drug.)

We have a great panel on medical spending called MEPS which includes age, medical history, prescriptions, income, and labor supply decisions. That is, we have everything we need for a quick diff-in-diff. Take those with joint pain and those without, before Vioxx leaves the market and after. We see parallel trends in labor supply before Vioxx is removed (though of course, those with joint pain are on average older, more female, and less educated, hence much less likely to work). The year Vioxx is removed, labor supply drops 10 percent among those with joint pain, and even more if we look ahead a few periods after Vioxx is taken off the market.

For more precision, let’s do a two-stage IV on the panel data, first estimating use of any joint pain drug conditioning on the Vioxx removal and the presence of joint pain, then labor supply conditional on use of an joint pain drug. Use of any joint pain drug fell about 50% in the panel following the removal of Vioxx. Labor supply of those with joint pain is about 22 percentage points higher when Vioxx is available in the individual fixed effects IV, meaning a 54% decline in probability of working for those who were taking chronic joint pain drugs before Vioxx was removed. How big an economic effect is this? About 3% of the work force are elderly folks reporting some kind of joint pain, and 20% of them found the pain serious enough to have prescription joint pain medication. If 54% of that group leaves the labor force, this means overall labor supply changed by .35 percentage points because of Vioxx (accounting for spillovers to related drugs), or $19 billion of labor income disappeared when Vioxx was taken off the market. This is a lot, though of course these estimates are not too precise. The point is that medical cost effectiveness studies, in cases like the one studied here, can miss quite a lot if they fail to account for impacts beyond QALYs.

Final working paper (IDEAS page). Paper published in AEJ: Applied 2012.

“Contractability and the Design of Research Agreements,” J. Lerner & U. Malmendier (2010)

Outside research has (as we discussed yesterday) begun to regain prominence as a firm strategy. This is particularly so in biotech: the large drug firms generally do not do the basic research that leads to new products. Rather, they contract this out to independent research firms, then handle the development, licensing and marketing in-house. But such contracts are tough. Not only can do I have trouble writing an enforceable contract that conditions on the effort exerted by the research firm, but the fact that research firms have other projects, and also like to do pure science for prestige reasons, means that they are likely to take my money and use it to fund projects which are not entirely the most preferred of the drug company.

We are in luck: economic theory has a broad array of models of contracting under multitasking worries. Consider the following model of Lerner and Malmendier. The drug firm pays some amount to set up a contract. The research firm then does some research. The drug firm observes the effort of the researcher, who either worked on exactly what the drug company prefers, or on a related project which throws off various side inventions. After the research is performed, the research firm is paid. With perfect ability to contract on effort, this is an easy problem: pay the research firm only if they exert effort on the projects the drug company prefers. When the research project is “tell me whether this compound has this effect”, it might be possible to write such a contract. When the research project is “investigate the properties of this class of compounds and how they might relate to diseases of the heart”, surely no such contract is possible. In that case, the optimal contract may be just to let the research firm work on the broader project it prefers, because at least then the fact that the research firm gets spillovers means that the drug firm can pay the researcher less money. This is clearly second-best.

Can we do better? What about “termination contracts”? After effort is observed, but before development is complete, the drug firm can terminate the contract or not. Payments in the contract can certainly condition on termination. How about the following contract: the drug firm terminates if the research firm works on the broader research project, and it takes the patent rights to the side inventions. Here, if the research firm deviates and works on its own side projects, the drug company gets to keep the patents for those side projects, hence the research firm won’t do such work. And the drug firm further prefers the research firm to work on the assigned project; since termination means that development is not completed, the drug firm won’t just falsely claim that effort was low in order to terminate and seize the side project patents (indeed, on equilibrium path, there are few side patents to seize since the research firm is actually working on the correct project!). The authors show that the contract described here is always optimal if a conditional termination contract is used at all.

Empirically, what does this mean? If I write a research contract for more general research, I should expect more termination rights to be reserved. Further, the liquidity constraint of the research firms matter; if the drug firm could make the research firm pay it back after termination, it would do so, and we could again achieve the first best. So I should expect termination rights to show up particularly for undercapitalized research firms. Lerner and Malmendier create a database from contract data collected by a biotech consulting firm, and show that both of these predictions appear to be borne out. I read these results as in the style of Maskin and Tirole; even when I can’t fully specify all the states of the world in a contract, I can still do a good bit of conditioning.

2008 Working paper (IDEAS version). Final paper in AER 2010. Malmendier will certainly be a factor in the upcoming Clark medal discussion, as she turns 40 this year. Problematically, Nick Bloom (who, says his CV, did his PhD part time?!) also turns 40, and both absolutely deserve the prize. If I were a betting man, I would wager that the just-published-in-the-QJE Does Management Matter in the Third World paper will be the one that puts Bloom over the top, as it’s really the best development paper in many years. That said, I am utterly confused that Finkelstein won last year given that Malmendier and Bloom are both up for their last shot this year. Finkelstein is a great economist, no doubt, but she works in a very similar field to Malmendier, and Malmendier trumps her by any conceivable metric (citations, top cited papers, overall impact, etc.). I thought they switched the Clark Medal to an every-year affair just to avoid such a circumstance, such as when Athey, List and Melitz were all piled up in 2007.

I’m curious what a retrospective Clark Medal would look like, taking into account only research that was done as of the voting year, but allowing us to use our knowledge of the long-run impact of that research. Since 2001, Duflo 2010 and Acemoglu 2005 are locks. I think Rabin keeps his in 2001. Guido Imbens takes Levitt’s spot in 2003. List takes 2007, with Melitz and Athey just missing out (though both are supremely deserving!). Saez keeps 2009. Malmendier takes 2011. Bloom takes 2012. Raj Chetty takes 2013 – still young, but already an obvious lock to win. What’s interesting about this list is just how dominant young folks have been in micro (especially empirical and applied theory); these are essentially the best people working in that area, whereas macro and metrics are still by and large dominated by an older generation.

“Inefficient Hiring in Entry-Level Labor Markets,” A. Pallais (2012)

It’s job market season again. I’m just back from a winter trip in Central Europe (though, being an economist, I skipped the castles and cathedrals, instead going to Schumpeter’s favorite Viennese hiking trail and von Neumann’s boyhood home in Budapest) and have a lot of papers to post about, but given that Pallais’ paper is from 2011’s job market, I should clear it off the docket. Her paper was, I thought, a clever use of a field experiment (and I freely admit by bias in favor of theoretically sound field experiments rather than laboratory exercises when considering empirical quantities).

Here’s the basic theoretical problem. There are a bunch of candidates for a job, some young and some old. The old workers have had their productivity revealed to some extent by their past job experience. For young workers, employers can only see a very noisy signal of their productivity. It involves a small cost to hire workers; they must be trained, etc. In equilibrium, firms will hire young workers who have expected productivity above the firm’s cost. Is this socially efficient? No, because of a simple information externality. The social planner would hire all young workers whose productivity plus the value of information revealed during their young tenure is above the firm’s cost. That is, private firms will not take into account that their hiring of a worker creates a positive externality from information that allows for better worker-firm matches in future periods. If yound workers could pay firms to work for them, then this might fix the problem to some extent, though in general such arrangements are not legal (though on this point, see my comment in the final paragraph). Perhaps this might explain the high levels of unemployment among the young, and the fact that absence from the labor market for young workers at the start of their career is particularly damaging?

How important is this? It’s tough in a lot of real world data to separate the benefits to workers of having their underlying revealed by early job experience from workers upgrading their skills during their first job. It is also tough to see the general equilibrium effects: if the government assists some young workers in getting hired, does this lead to less unemployment among young workers in future periods or do these assisted workers simply crowd out others that would have been hired in the absence of the intervention? Pallais uses an online job market similar to mechanical turk. Basically, on the site you can hire workers to perform small tasks like data entry. They request a wage and you can hire them or not. Previous hires are public, as are optional ratings and comments by the employers. Empirical data on past interventions is somewhat ambiguous.

Pallais hires a huge number of workers to do data entry. She randomly divides the applicants into three groups: those she doesn’t hire, those she hires and gives only minimal feedback, and those she hires and provides detailed comments. The task is ten hours of simple data entry with no training, so it’s tough to imagine anyone would infer the workers’ underlying human capital has improved. Other employers can see that Pallais has made a hire as soon as the contract begins, but the comments are added later; there is no effect on workers’ job offers until after the comments appear. And the effect appears substantial. Just being hired and getting a brief comment has a small impact on worker’s future wages and employment. A longer, positive comment has what looks like an enormous impact on the worker’s future employment and wages. Though the treatment does lower wages received by other people on data entry jobs by increasing the supply of certified workers, the overall increase in welfare from more hiring of young workers trumps the lower wages.

Interesting, but two comments. First, for some reason the draft of this paper I read seems to suggest some sort of idea that this sorting is good for workers, if only between the lines. But it needn’t be so! A simple model: all firms are identical, and have cost .4 of hiring a worker. Workers have skills drawn from a uniform [0,1] distribution. No signals are received in the first period. Therefore, all workers have expected skill .5, and all are hired at wage .1 (by the no profit condition in a competitive labor demand market). After the first hiring, skill level is completely revealed. Therefore, only 60% of workers are hired in the second period, at a wage equal to their skill minus .4. A policy that ex-ante would have revealed the skill of young workers would have decreased employment among young workers by 40 percent! Note that this would be the efficient outcome, so a social planner who cares about total welfare would still want to reveal the skill, even though the social planner who cares only about employment would not do so.

Second, to the extent that skill revelation is important, young workers with private information about their skills ought self-select. Those who believe themselves to be high type should choose jobs which frequently throw off public signals about their underlying quality (i.e., firms that promote good young folks quickly, industries like sales with easily verifiable output, etc.). Those who believe themselves low type should select into jobs without such signals. If everyone is rational and knows their own type, you can see some unraveling will happen here. What has the empirical career concerns literature learned about such selection?

November 2011 working paper (No IDEAS version). I see on her CV that this paper is currently R&Red at AER.

Learning and Liberty Ships, P. Thompson

(Note: This post refers to “How Much Did the Liberty Shipbuilders Learn? New Evidence for an Old Case Study” (2001) and “How Much Did the Liberty Shipbuilders Forget?” (2007), both by Peter Thompson.)

It’s taken for granted now that organizations “learn” as their workers gain knowledge while producing and “forget” when not actively involved in some project. Identifying the importance of such learning-by-doing and organizational forgetting is quite a challenging empirical task. We would need a case where an easily measurable final product was produced over and over by different groups using the same capital and technology, with data fully recorded. And a 1945 article by a man named Searle found just an example: the US Navy Liberty Ships. These standardized ships were produced by the thousand by a couple dozen shipyards during World War II. Searle showed clearly that organizations get better at making ships as they accumulate experience, and the productivity gain of such learning-by-doing is enormous. His data was used in a more rigorous manner by researchers in the decades afterward, generally confirming the learning-by-doing and also showing that shipyards which stopped producing Liberty ships for a month or two very quickly saw their productivity plummet.

But rarely is the real world so clean. Peter Thompson, in this pair of papers (as well as a third published in the AER but discussed here), throws cold water on both the claim that organizations learn rapidly and that they forget just as rapidly. The problem is two fold. First, capital at the shipyards was assumed to be roughly constant. In fact, it was not. Almost all of the Liberty shipyards took some time to gear up their equipment when they began construction. Peter dug up some basic information on capital at each yard from deep in the national archives. Indeed, the terminal capital stock at each yard was three times the initial capital on average. Including a measure of capital in the equation estimating learning-by-doing reduces the importance of learning-by-doing by half.

It gets worse. Fractures were found frequently, accounting for more than 60% of ships built at the most sloppy yard. Speed was encouraged by contract, and hence some of the “learning-by-doing” may simply have been learning how to get away with low quality welding and other tricks. Thompson adjusts the time it took to build each ship to account for an estimate of the repair time required on average for each yard at each point in time. Fixing this measurement error further reduces productivity growth due to learning-by-doing by six percent. The upshot? Organizational learning is real, but the magnitudes everyone knows from the Searle data are vastly overstated. This matters: Bob Lucas, in his well-known East Asian growth miracle paper, notes that worldwide innovation, human capital and physical capital are not enough to account for sustained 6-7% growth like we saw in places like Korea in the 70s and 80s. He suggests that learning-by-doing as firms move up the export-goods quality ladder might account for such rapid growth. But such a growth miracle requires quite rapid on the job productivity increases. (The Lucas paper is also great historical reading: he notes that rapid growth in Korea and other tigers – in 1991, as rich as Mexico and Yugoslavia, what a miracle! – will continue, except, perhaps, in the sad case of Hong Kong!)

Thompson also investigates organizational forgetting. Old estimates using Liberty ship data find worker productivity on Liberty ships falling a full 25% per month when the workers were not building Liberty ships. Perhaps this is because the shipyards’ “institutional memory” was insufficient to transmit the tricks that had been learned, or because labor turnover meant good workers left in the interim period. The mystery of organizational forgetting in Liberty yards turns out to have a simpler explanation: measurement error. Yards would work on Liberty ships, then break for a few months to work on a special product or custom ship of some kind, then return to the Liberty. But actual production was not so discontinuous: some capital and labor transitioned (in a way not noticed before) back to the Liberty ships with delay. This appears in the data as decreased productivity right after a return to Liberty production, with rapid “learning” to get back to the frontier. Any estimate of such a nonlinear quantity is bound to be vague, but Peter’s specifications give organizational forgetting in Liberty ship production of 3-5% per month, and finds little evidence that this is related to labor turnover. This estimate is similar to other recent production line productivity forgetting estimates, such as that found in Benkard’s 2000 AER on the aircraft industry.

How Much did the Liberty Shipbuilders Learn? (final published version (IDEAS page). Final version published in JPE 109.1 2001.

How Much did the Liberty Shipbuilders Forget? (2005 working paper) (IDEAS page). Final paper in Management Science 53.6, 2007.

“When the Levee Breaks: Black Migration and Economic Development in the American South,” R. Hornbeck and S. Naidu (2012)

Going back at least to Marx, surplus labor particularly in the countryside has been considered the enemy of labor-saving technological progress. With boundless countryside labor, either because of force (serfdom, slavery, etc.) or other limited opportunities for migration, landowners can lack the incentive to adopt new labor-substituting technologies that they might otherwise adopt. This story anecdotally applies to the American South. From 1940 to 1970, a second “Great Migration” of African-Americans fled the South toward industrial cities in the North with high labor demand. Simultaneously, the South began adopting farming technology that had been much more common in the North and Midwest. These African-American workers were often part of a paternalistic relation with their employers which imposed relatively large moving costs on potential migrants before 1940. But is there any cause and effect here? Was the industrial boom in the heartland the cause of modernization in the South?

Naidu and Hornbeck (two of the best young economic historians in the world; more on this shortly) examine this by looking at the 1927 flood of the Mississippi river. During this flood, large number of black workers in the Delta were forced to move to Red Cross camps, where networks formed that led many of the workers to head to cities like Chicago; blatant abuse of the Red Cross system by white planters certainly served as an additional incentive. In the Delta, mule use as well as tractors for transportation of cotton to the gin was very limited.

Imagine that the cost of black labor increases, as happened during the flood due to the ease of labor moving North from the aid camps. In a simple model where black labor, white labor and capital are substitutes, the one-time increase in black wages increases capital use, decreases land value (due to the loss of exploitable black labor paid less than MP due to moving cost), and increases white labor (which was assumed to be part of a national labor market already). The authors examine this model using a difference-in-difference applied to counties which were flooded and other non-flooded counties in the Delta.

Flooded counties lost 14% of their black population after the flood. Flooded counties adopt mules and horses at a higher rate than non-flooded counties by 1930, and quickly replace these farm animals with tractors. The use of tractors causes average farm size to rise in flooded counties over the next 30 years; large average farm size, worldwide, is highly correlated with productive farming. Profits of one large landowner with accessible records sees no change in profits despite the modernization of inputs. There are many robustness checks, but overall this is a convincing case that the South modernized when labor costs were relieved from their artificially low pre-flood level.

August 2012 NBER Working Paper (IDEAS page)

(P.S.: If this type of work interests you, take a quick peek at some of the other work the coauthors have been doing. Hornbeck’s recent AER shows in great detail the slow economic adjustment to the Dust Bowl’s short-run effects, with great relevance to current climate change policy, and his 2010 QJE with Greenstone and Moretti which uses large industrial plant “contests” to study local knowledge spillovers is the state of the art on the question. Naidu has a forthcoming AER on how pseudo-slavery relations (roughly, labor contracts enforced in criminal courts in 19th century Britain) were used to smooth labor market risk, as well as a great 2011 paper showing clear-as-day evidence that someone aware of secret coup plotting in the US during the Cold War was using that knowledge to profit in the stock market. Naidu also does some cool evolutionary game theory work with the always-great Sam Bowles.)

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