The mystery of the human and the trade-offs of control

By Lorenzo

What is the biggest difference in decision-making between buying equipment and hiring a person?  The characteristics of the equipment are much easier to discern.

Sure, there can be hidden flaws in machinery and buildings. You may have to take the equipment for a test run, you may need some expert to have a look at it, but, in a very important sense, what you see is what you get. And, once you are used to one example of a piece of equipment, the next item of the same thing is likely to have the same characteristics. Indeed, the higher quality the provider, the more reliable this sameness is.

People are so not like that. They vary greatly in ways which matter to an employer (or, indeed, anyone else seeking to interact with them) but which are not easy to discern. The only reliable way to find out about a particular person is to interact with them. [UPDATE. Nobel Laureate James Heckman has co-written a study on how “soft skills” matter (pdf) (via), on how personality traits affect life outcomes yet can be hard to assess.]

Who is telling me
Much of how labour markets work is dominated by the opacity of relevant personal characteristics. For example, the biggest labour market intermediary (way people get jobs) is generally “friends, relatives, acquaintances, etc”–someone they know told them about the job and/or the employer about them.

You can spread information about a job much more easily by posting a job vacancy.  But that will tell you almost nothing about the applicants. Personal networks provide much richer information; even if it is just “I don’t know Bob, but Kate recommended him and Kate wouldn’t steer me wrong” and/or “I have a high regard for Kate’s judgement”. You can judge the recommendation on the reliability of the recommender and to what extent the recommender is, in effect, acting as a guarantor (so as to avoid harming your existing connection).

Recommendation through existing networks thus becomes a proxy for judging the personal characteristics you cannot directly discern.

It tells me what
?Such proxies abound. Has someone else taken the risk of hiring you? If yes, have they persisted in that choice for any length of time?  Hence the best place from which to get a job is being already in one. Does your education suggest that you have application and persistence? Hence the value of education qualifications is surprisingly weakly connected to the alleged content of that education. And so forth.

This is where making it hard to sack someone (in Australia “unfair dismissals” legislation) tends to so retard the operation of labour markets, for it greatly increases the risk in hiring someone precisely because of the opacity of personal characteristics. If the minimum cost of getting rid of a complete dud is, say, $3,000 in legal fees, employer time and “go away” money, then that adds a $3,000 risk premium to every hire. This is then offset by not hiring if it pushes the risk too high for expected benefits or relying even more heavily on other filtering mechanisms. Both responses hit the most marginal would-be labour market entrants hardest. But, like much labour market regulation (indeed, much regulation generally), job-protection legislation is about protecting incumbents.

It also weakens the signal of simply being in a job, as the employer’s persistence in keeping you becomes a weakened recommendation.

What can I tell?
Given the difficulty in discerning the relevant characteristics, the harder it seems to “read” someone, the less attractive they are as employees. Language and cultural differences–to the extent they seem to make it harder to discern characteristics, communicate information and predict behaviour–become an employment negative. Effects which can be hard to distinguish from actual ethnic antipathy.

So, if you are a young Muslim male in a Western European country with strong “job protection” legislation, your chances of employment are not good. Or even just being young; there are reasons why France exports young people to Britain (while Britain exports retirees to France), as these job emigres in London (helping to make London France’s sixth biggest city) can attest:

Marine Schepens, who works for a fashionable advertising agency, says UK companies are more prepared to give young people a chance because it is easier to terminate their contracts than in France.

“I changed careers a year ago but I would have never done that if I was still in France. I’d have thought, ‘I’m so lucky to have a job – I must hang on to it.'” …

Hamid Senni, a business consultant based in London, was one of eight children born to Moroccan immigrants in the south of France. A well-meaning teacher at his school suggested he change his name to Lionel.

“Because of your name you will be discriminated against, because of your skin colour, and even the address on your CV can stop you from getting a job … As for your skills and competencies – none of that counts in France if you don’t fit in the box – so I left”

Making employing people riskier is also not good for social integration.

Conversely, once you have a clear (and sufficiently positive) sense of an employee, you want to hang on to them. They are a known quantity; and merely being a known quantity is a positive in itself.

A further difference between buying equipment and hiring an employee: equipment tends to wear out over time. Employees tend to become more productive over time (though generally at a diminishing rate). Another reason to hang on to existing employees if you can.

Both employees and equipment tend to perform better if you treat them better; well-maintained equipment and well-treated employees are both more reliably productive. It makes sense for larger corporations–who cannot supervise their employees’s contributions to productivity nearly as well as small businesses can–to pay a “hostage premium” (over-the-market-wages) to encourage employees to police themselves (trading off the weaker ability to supervise against more to lose from not performing); it is not surprising that large corporations tend to pay better than small businesses.[i]

It is a feature of economic downturns that hiring and investment falls. Firms tend not to add to their stock of equipment or workers, because they lack confidence in the ability to sell what they will produce. It is also a feature of downturns that asset prices can fall (sometimes dramatically) but wages are notoriously “sticky” downwards (i.e. they tend not to fall even in a major downturn).

Who is being told
?The last is for good reasons. The lower and the less diversified income someone’s income is, the more adverse to income volatility (particularly downward) they can be expected to be. People can also be expected to be adverse on taking on risk without control. The less control they have, the more risk-adverse they are likely to be. Central to being employed is to be under direction (whether in a direct sense or via preset duties) of the employer or agent thereof; part of the trade-off being to reduce downward risk via a floor under rates of payment. Viewing an employment contract as if it “should be” a commercial contract (able to respond up and down to shifting prices) is to mistake its nature: the element of being under direction makes it not a commercial contract in precisely its risk/control trade-offs. A trade-off which makes it attractive to people with only one income source, their labour.

Thinking of people as being paid “real wages”–the goods and services purchasable at a given wage rate–is highly misleading. Employers and employees cannot control the price level. To not specify the agreed wage rate in money is to give up the enormous information and transactional advantages of money. That, with the employment contract control/risk trade off in an agreed minimum rate, generates “sticky” wages. (That employers care about the cost of labour compared to the prices of their product while employees care about the wages received compared to the prices of their varied purchase patterns can also make talking about “real wages” misleading.)

Nominal stickiness (the agreed number of measures being more resistant to change than actual content) has a long history. In James C Scott’s Seeking Like A State  (excellent book, btw, thanks to commenter DerriderDerrider for recommending it), he discusses feudal lords shortening or lengthening measures so as to squeeze more out of the peasants. For example, paying wages in smaller baskets than those used to collect dues in. The obligations remained nominally constant while the actual content (the real value) changed. One estimate is that the size of bushel (boisseau) used to collect the main feudal rent (taille) in France increased by a third between 1674 and 1716. As Scott notes:

What was seen as customary might not have had a very long pedigree. It was always in the interests of at least one party, who feared a disadvantageous renegotiation, to treat the existing arrangements as fixed and sacrosanct (Chapter 1, n42).

Obviously, such levies being compulsory made it easier for feudal lords to play such games. But, even so, having a set nominal amount probably retarded the rate at which such games could be played.

If you are an employee under the direction of another, then constraining what that direction costs means being constraining disadvantageous explicit or implicit renegotiation. Nominal measures provide easily identifiable and manageable constraints on contractual and other obligations, a basic conceptual language of contracts and specified obligation. Employment relationships being, in effect, long-term games with strong contagion effects (how you treat one employee has implications for others) on a payment-for-effort basis, employees need to be reassured that–in terms of things controllable by the bargainers, because that is the bargaining frame they are in–they will not go backwards from sticking around and being subject to direction, such as being lumped with downward income risk and lack of control. A fixed minimum payment for a given output, in the units that also pay their other obligations, does that. (Employees do not, after all, get negative bonuses.)

The premium on both being a known quantity and on being used to the needs of the firm encourage  wages (especially hourly rates) to be “sticky” downwards. Especially as the fall in hirings and resignations during downturns mean that current employment relationships are “stretched out”. Trying to get someone to be paid less for the same output being not a good basis for a positive on-going relationship, cutting back hours is therefore preferable to cutting rates. But the risk/direction trade-off inherent in the employment contract is the crucial element.

Which then pushes management of risk back to where control lies. If an employer seeks to insist on control yet also pass on income risk, they undermine the basic nature of the employment contract trade-off (they are changing category, like the Red Cross suddenly charging for doughnuts) and their own status as a bargainer; not only with current workers but also future ones. If the contract does not constrain you, why should it constrain them to be productive? So it is better to terminate an employment relationship rather than poison continuing and future ones; and even better to keep existing employees and respond to lowered demand for your goods or services by not hiring new employees rather than engaging in some “bidding war” between current and possible employees. Hence levels of employment respond far more than wage rates to economic downturns.

Equipment, on the other hand, has no reaction to how you price it. You can cut back its use as much as you want. But, given it is used across several time periods, its value is deeply affected by expectations. Hence prices of equipment and other assets are far more volatile, both up and down, than wage rates. And if employers want to pass on risk, they also have to pass on control (pdf).

Austrian school economists make a great deal of the heterogeneity of capital; of how a machine built to do x represents resources that cannot easily be redeployed. But the heterogeneity of labour is at least as important economically. It is true that people can be amazingly flexible. But the variety and mystery of the human–their heterogeneous opacity–is crucial to understanding how labour markets work. Along with the nature of the employment contract as trading being under direction for a risk-constraining agreed basic wage rate.

UPDATE: Daniel Kuehn likes the post and has some extra comments:

makes me wonder why workers would implicitly accept risks associated with layoffs. I think part of the problem also has to do with nominally fixed expenditures that people get into a habit of making. Certain consumer prices can move, of course. But others can’t. The more nominally rigid your expenditures, the more you’re going to want to guarantee a nominal income stream. Getting a wage cut to preserve your job may not be all that attractive with nominally rigid expenditures. You might prefer to take the risk of losing your job.

This seems correct to me. That you have to think in terms of the nominal expenditure commitments of workers is a point I have made in various comments before, but Daniel expresses it better.


[i] Which is the opposite of what the “unequal bargaining power” (pdf) theory would predict. But that theory would also predict that large supermarkets would be more expensive than small corner shops. “Unequal bargaining power” is a very useful theory for justifying regulation but not a good basis for understanding how things actually work. It is the alternatives available, not merely the relative “sizes” of the bargainers, that matter–hence complaints about Coles and Woollies treatment of their suppliers; their suppliers have such limited alternatives.

14 Comments

  1. kvd
    Posted July 18, 2012 at 10:24 am | Permalink

    Excellent piece Lorenzo. Thank you!

    I’d add one other consideration – affects both sides – and that is geography. Probably more significant to small business than large (although large decentralised operations exist) but the lack of a large pool of potential employees makes getting and keeping good ones quite important.

    Offset, I guess, on the employee side by choosing to reside in an area of limited employment opportunities.

  2. Posted July 18, 2012 at 10:54 am | Permalink

    [email protected] Glad you liked it. I suspect one of the difficulties of labour economics is that almost everyone who writes about it is an employee. Having experience on both sides (and I mean when your own capital and income is at risk in your hiring decisions) gives you a different perspective.

    On geography, yes it matters. Indeed, Krugman recently got a Nobel Prize on that (his Nobel lecture is well worth watching.)

  3. kvd
    Posted July 18, 2012 at 12:41 pm | Permalink

    Lorenzo, hopefully not to divert too much, but I found this analysis very interesting. Is there an Australian equivalent record that you know of?

    (and I didn’t realise that about Krugman; I will watch his lecture tonight. Thanks for link)

  4. Posted July 18, 2012 at 2:29 pm | Permalink

    [email protected] Natsem works on that sort of thing.

    Krugman lecture is not only fascinating on trade and the economics of geography, it is a very nice insight into how to do social science.

  5. Posted July 19, 2012 at 6:46 am | Permalink

    [email protected] That is the National Centre for Social and Economic Modelling at the University of Canberra.

  6. derrida derider
    Posted July 19, 2012 at 9:30 am | Permalink

    Another excellent post with many good things in it. I could make a long comment drawing out the many more implications of unverifiability and inseperability of future (or indeed present) marginal product and the consequent pervasive information asymmetries – it is in fact what makes labour economics a distinctive field of study.

    As an example there is a respectable theoretic case that Employment Protection Legislation (EPL in the jargon) need not be inefficient. If you believe, as “New Labor Economics” adherents do, that employers make rents (“matching rents”) from existing employment contracts (that is, local monopsony created by search costs mean that wages and conditions are less than marginal product so there is exploitation in the technical Marxist sense) then the costs of dismissal borne by the employee are greater than the benefit to the employer. There is a large externality here which we “tax” (badly – it would be much better to have an explicit termination tax rather than have all the expense, time and hassle of going to law). It’s the same case as for hiring subsidies, just in reverse.

    Plus when you work it through you can see that whether EPL raises unemployment levels is theoretically ambiguous (sure it slows flows INTO employment, but it also slows flows OUT), and repeated empric studies (especially by the OECD, a body gung-ho for labour market “reform”) have failed to find an associaton between EPL and aggregate unemployment.

    The effect you point to, though – that EPL differentially pushes members of “high risk” groups into long term unemployment in the same way that preventing landlords evicting tenants locks “high risk” tenants out of the rental market – is very clear in the data. EPL encourages statistical discrimination and changes WHO is unemployed more than how many are unemployed. Not a Good Thing if you value social inclusion.

  7. derrida derider
    Posted July 19, 2012 at 9:48 am | Permalink

    PS kvd’s comment is interesting if you’re interested in New Labor Economics (NLE). One of the big successes of NLE has been in providing a plausible, testable and empirically tested explanation of the Employer Size Wage Effect – ESWE. ESWE – that identical employees in identical jobs get paid more in a large business than a small business – has long been known but was long unexplained

    But I’m wondering now if the variation in market power over employees driving this arises from geographic features rather than from variation in observabilty of marginal product. I’ll have to look at some empiric papers to see if they control for it.

  8. Posted July 19, 2012 at 11:22 am | Permalink

    [email protected]

    There is a large externality here which we “tax” (badly – it would be much better to have an explicit termination tax rather than have all the expense, time and hassle of going to law)

    But that would not give employment to Labor Lawyers. Also, a tax would help unions organise stable workforces but probably not be as good a “we are working for you” signalling device.

    And I now remember that any unemployment effect was small (although I wonder if it varies by business size); but that never impressed me because it seemed obvious that the filtering effect would be significant.

  9. Posted July 19, 2012 at 11:27 am | Permalink

    [email protected] Not familiar with that literature: would not the search costs go both ways?

  10. Posted July 19, 2012 at 11:43 am | Permalink

    Good post.

    Which is the opposite of what the “unequal bargaining power” (pdf) theory would predict. But that theory would also predict that large supermarkets would be more expensive than small corner shops.

    I haven’t had time to read that pdf, however I’m not an ‘unequal bargaining power’ would claim to predict anything about the actual outcomes between large and small shops because there are far too many other variables that wouldn’t be covered by such a theory. That doesn’t mean that unequal bargaining power is irrelevant to outcomes though.

    It is the alternatives available, not merely the relative “sizes” of the bargainers, that matter

    It’s also important to consider the transaction costs of change for each party relative to their ability to manage the costs. If one party has the ability to take the change in their stride while the other faces significant hardship or risk from the change then there will be a significant difference in bargaining power.

  11. Posted July 19, 2012 at 1:12 pm | Permalink

    [email protected] Considering the alternatives available would surely also mean considering the cost of switching. It’s the real choices people face that matter, not the notional ones. (See my comment about suppliers to Coles and Woollies.)

  12. derrida derider
    Posted July 19, 2012 at 3:34 pm | Permalink

    [email protected], yes. But NLE generally models the game as the employer having a more credible threat point because it assumes away the cost to the employer of labour turnover – or, equivalently, it assumes local monopsony rather than bilateral monopoly.

    My own view is that this is not a serious problem for unskilled jobs in slack labour markets (where the cost to the employee of termination is going to be far bigger than the cost to the employer) and so you can use it for things like minimum wage policy, but it may be inappropriate in other contexts (though as noted it does well on some things like ESWE)..

    For the literature I’d start with Alan Manning’s book “Monopsony in Motion”, although the primary literature is a bit more game-theory oriented.

  13. Posted July 20, 2012 at 8:08 am | Permalink

    [email protected], I agree with your point about real choices, just that I would have considered it a basic part of any ‘bargaining power’ analysis.

  14. Posted July 20, 2012 at 3:33 pm | Permalink

    [email protected] Which is the way I was conceiving it, so we seem to be in furious agreement.

    [email protected] That does seem like a useful book. It is, alas, a bit away from the concerns I wish to focus on, but I have put it on my Amazon list.

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