Marginal Productivity Theory and the Mainstream

In an earlier discussion on the state of orthodox economics hosted by TPM Café, I posted an article excavating the microeconomic foundations of neo-classical economics. In that article I wrote:

“There is one place that even orthodox lefties dare not go. That untouchable place is marginal product theory of income distribution, which basically says that competitive markets ensure that people are paid their contribution to production. This theory provides both a justification and an explanation of income distribution.”

Dani Rodrik has challenged this claim in a blog titled “Do heterodox lefties have a better grasp on reality than neo-classical lefties?” As one would expect anything Dani writes is thoughtful and constructive. Let me try and develop some further insights.

Dani’s counter is that the mainstream empirical literature on pay determination is full of references to the impact of institutions, particularly unions. He also points to his own paper titled “Democracies Pay Higher Wages” that was published in the Quarterly Journal of Economics (QJE). That paper shows that bargaining environment, and especially the degree to which the political system is democratic, exerts a significant impact on labor’s share of the surplus. Democracy can raise wages by as much as fifty percent, controlling for productivity. I agree with this, although in a separate paper titled “Democracy, Labor Standards and Wages” I have argued democracies work their wage effects through better labor standards that they promote.

On the basis of this Dani concludes that (1) neo-classical economics is not averse to going beyond marginal productivity theory, and (2) the fact his paper was published in the mainstream establishment QJE suggests orthodox economics is not closed.

Dani is absolutely right about the empirical literature on pay, which is broad and multi-faceted. The question is what is the relation of that literature to marginal product theory and does it move mainstream economics beyond marginal product theory? I suggest not.

When it comes to unions, it is well documented that unions raise wages. Union supporters argue that (especially in highly unionized economies) unions do so with no adverse employment effects. Neo-classicals interpret unions through a marginal product labor demand lens, and generally argue they raise wages at the cost of lower employment. However, it is also the case that if employers have monopsony (buyer monopoly) power unions can also raise both wages and employment in a marginal product framework.

What about democracy? I suggest democracy raises wages by altering the division of the cake, but there is no adverse employment effect. Furthermore, by raising wages and improving income distribution, democracy strengthens consumer demand and may increase employment through a Keynesian channel. This is an argument based on a non-marginal product approach to income distribution.

What does neo-classical marginal productivity theory imply about democracy? Holding productivity constant, democracy would tend to lower employment because it raises wages. However, as with unions one could argue democracy lowers the monopsony power of employers, thereby raising both wages and employment. Under this neo-classical interpretation, democracy serves to move the economy closer to the idealized state of perfect competition in which the idealized version of marginal productivity theory of income distribution holds.

The bottom line is there are two stories about the wage effects of democracy (and unions) - one rooted in marginal product theory, the other not. My view is the institutionalist – Keynesian story is more plausible. I am not sure what Dani’s view is, as he seems to support both. However, that seems theoretically problematic.

When it comes to the neo-classical theory of income distribution you are either in or out with regard to the concept of marginal product. Under conditions of perfect competition, the marginal product of labor is the labor demand schedule, which tightly determines the relationship between wages and employment as a technological relationship. Under conditions other than perfect competition, the marginal product of labor remains ever-present and provides the reference point for determination of wages. However, if marginal product is an incoherent or unusable concept most of neo-classical economics (including its approach to income distribution) disintegrates: hence, the unwillingness to question marginal product analysis.

The bigger story is that the empirical data settle nothing and can be interpreted to be consistent with either theory. That suggests both should be taught with equal prominence in all economics departments, including top departments. Yet they are not. Instead, only the neo-classical marginal productivity theory is taught as part of the core curriculum, the concept of marginal product is never questioned, and heterodox theory is essentially suppressed.

Recently MIT economists Peter Temin and Frank Levy have published a paper about the role of institutions in explaining inequality in 20th century America. Their paper is welcome – and (to be self-promoting) expands analytical themes developed in my 1998 book, Plenty of Nothing: The Downsizing of the American Dream and the Case for Structural Keynesianism. The engagement of these economists may be a sign that the economics profession’s thinking about income distribution is headed for change. If that is so, neo-classical economics will be in serious trouble because marginal productivity theory figures critically in its macroeconomics (both new classical and new Keynesian), its microeconomics, and it approach to trade and globalization.

Lastly, Dani argues the publication of his paper in the QJE is evidence of mainstream openness. I am delighted the QJE published his paper because it is a leading journal, which means the paper got wide circulation. However, the paper was issued earlier by the National Bureau of Economic Research and Dani is a Harvard professor. Both of those facts matter. The scuttlebutt is that the QJE is the Harvard/MIT working papers series, as evidenced by the extraordinarily large proportion of articles accepted from those faculties. This is just another example of the sociology of economics that my TPM Café discussion also emphasized.

[Note: I am re-posting this article because I think the original did not hit its target cleanly]

Copyright Thomas I. Palley

8 Responses to “Marginal Productivity Theory and the Mainstream”

  1. Justin Says:

    I am delighted the QJE published his paper because it is a leading journal, which means the paper got wide circulation. However, the paper was issued earlier by the National Bureau of Economic Research and Dani is a Harvard professor. Both of those facts matter. The scuttlebutt is that the QJE is the Harvard/MIT working papers series, as evidenced by the extraordinarily large proportion of articles accepted from those faculties.

    Yeah, so much for double-blind review, I guess. If double-blind review really existed, it’s unlikely that such a bias in favor of Harvard-MIT working papers would persist. If the journal were serious about academic standards, it would require that submissions not be pre-published elsewhere.

  2. David Bunnett Says:

    Fascinating discusssion. I read the TPM piece and also the Nation article. Perhaps at last there is some hope of escape from the dark gravity of neo-classical economics, which to this non-economist seems too much like self-serving dogma produced by and for wealthy pirates.

    Somewhere along this excursion there was discussion of multiple agency, the notion that individual economic decisions are not made by a single atomic entity, that in fact people have multiple ways they could evaluate a particular choice. My hope is that the “wealthy pirates” referenced above will activate one of these alternative valuing methods within themselves, in time to realize that being wealthy in a world that is burning up might be of less utility than being slightly poorer in a world that is actually habitable.

    Finally, I enjoyed the definition provided for mainstream econimic thought: that which is produced by mainstream economists and published in mainstream journals. LOL!

  3. liberal Says:

    That untouchable place is marginal product theory of income distribution, which basically says that competitive markets ensure that people are paid their contribution to production.

    One thing economists seem not to understand (or choose to ignore) is that landowners qua landowners make no contribution to production, and yet get compensated with 10–20% of GDP in the US.

    Of course, one could reasonably define the problem away by pointing out that there’s nothing competitive about state-granted title to land.

  4. rob beasley Says:

    how exactly would one describe a neoclassicalist? what it the difference in policy approaches bectween neoclassicalists, neokeynesians, post-keynesians, and whatever you call yourself? I was always confused by all the labels. I kknow the classical, I know the keynesian taught in undergrad econ classes, but do not follow the rest.

  5. John Médaille Says:

    The easy but unexamined assumption of Marginal Productivity is that it is productivity which is marginalized. But a glance at the actual statistics makes this assumption rather doubtful. Wages have stagnated in the face of rising productivity, a phenomenon counter to the theory. The truth is that contract negotions are based on power, hence MP marginalizes power, not productivity. The CEO does not make 500 times more than the line worker because he is 500 times more productive, but because he is 500 times more powerful. The seamstress in a sweatshop does not make a bare subsitence because she lacks productivity but because she lacks power.

    Further, the theory is flawed to begin with because it posits severable factors of production, factors which can be independently calculated. But this is incorrect. Production is a social process that occurs at the intersection of land, labor, and capital. Capital without labor is sterile; labor without capital is simply another name for unemployment. The factors cannot be varied indpendently. To add labor means using up the capital faster; to add capital means changing the nature of labor. (For example to replace shovels with backhoes changes the worker from a “shovel-operator” to a back-hoe operator.)

    The theory looks plausable because it looks like a mere extension of the intuitively obvious law of diminishing returns. But this is a composition fallacy. The truth is that since production is a social process, you can only compare the productivities of a processes, not of factors within a process. Allocating the factors within a process is a matter of managerial judgment for which no precise mathematics exist, or can exist.

    If I may be forgiven for plugging my book, (The Vocation of Business: Social Justice in the Marketplace), I have chapter on “Marginal Productivity and the Just Wage” which develops these arguments in greater detail. The chapter may also be viewed at my web site.

  6. fabio petri Says:

    It is not true that marginal productivity theory has been left untouched by ‘orthodox lefties’. The Sraffians have criticized it thoroughly. May I mention my book General Equilibrium, Capital and Macroeconomics (Edward Elgar, 2004) as a recent comprehensive account of this critique.

  7. Anarcho Says:

    Joan Robinson also critiqued the whole concept in the 1950s and 1960s, pointing out that it is impossible to actually define what a unit of capital is and so it is impossible to add another unit to an existing stock in order to work out its marginal productivity.

    Defenders of the concept come out with nonsense when they are trying to defend it. One even suggested that we could work out the marginal productivity of factors when you add another worker to nine spades by turning them into ten cheaper ones! As if that were remotely possible in reality (this is discussed in section C.2 of An Anarchist FAQ).

    I would say that most economists these days know nothing about these debates, probably because the critics won them — and the neoclassical economists admitted as much. Mainstream economics seems to be as good as ignoring valid criticism as it is ignoring reality.

  8. Hip Heterodoxy Again: Tom Palley on Income Distribution | Ulrich Fritsche Says:

    [...] is a quite thoughtful post by Tom Palley: Last week as part of a discussion on the state of orthodox economics hosted by TPM [...]