"Marginal Productivity Theory and the Mainstream"

Thomas Palley with more on the acceptance of heterodox views within the economics profession. Thomas discusses the neoclassical theory of income distribution. Since this theory was first published by J. B. Clark over a century ago, it has been controversial. J.M. Clark, his son and also a prominent economist, wrote that his father's ideas on marginal productivity and the distribution of income are ethical statements "oriented at Marx, and are best construed as an earnest, and not meticulously qualified, rebuttal of Marxian exploitation theory." Clark believed that each factor of production would receive a return just equal to its contribution to society (the value of its marginal product) and hence the distribution of income was ethically correct.

There have been many, many objections to the normative conclusions drawn by Clark from his marginal product theory. To name a few, it requires perfect competition, it rewards factors, not individuals (owning capital and land gives the owners income, but the income is for the contribution of the factors, not for the contributions of individuals receiving the income), there is no meaningful way to separate the contributions of factors to total product (when crops grow, was it the hoe used to weed the plot of land, or the person operating it?)

Marginal productivity theory gives an explanation for why income is distributed in a particular way. The question is whether it provides an adequate theory for understanding the flow of income to the factors of production, and I think it does provide such a basis. So it helps us to understand why income is distributed as it is, but arguing about whether the result is equitable or not is fruitless since it will depend upon the definition of equity used to evaluate the outcome, and the definition can differ across individuals.

My own view is that we don't need, at least not yet, to discard the standard theoretical model. Instead, and there has been a lot of work in this direction, we should first be sure that incorporating market and political power relationships into the standard structures won't explain what we observe in the world. Dani Rodrik states this as "I think the best antidote against the blind spots is neoclassical economics itself." When someone invokes marginal productivity theory's ethical implications, as they do, say, when they argue that CEO pay is justified because it reflects CEO's contributions to the firm's output (and hence to society more generally), they are implicitly assuming that the assumptions of the perfectly competitive market hold when it's doubtful that they do. Markets can fail in a variety of ways and the neoclassical model of pure competition can serve as a useful benchmark for understanding how departures from an idealized structure will resolve themselves as people interact in the marketplace. Too many people argue from the standpoint of the perfectly competitive model when it simply doesn't apply and I would be happy, at least as a start, if the discussions of these issues would do a better job at recognizing that the competitive model is an idealized benchmark to evaluate actual markets, but not an outcome we should necessarily expect in the real world. Here's Thomas [Note: Thomas has updated this post - see the new edition that is posted below]:

Marginal Productivity Theory and the Mainstream, by Thomas I. Palley: Last week as part of a 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 significance of that literature for marginal productivity theory and the economics profession?

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. Marginal productivity theorists argue they do so at the cost of lower employment.

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 a non-marginal productivity theory argument that cannot be rendered consistent with marginal productivity theory.

What does neo-classical marginal productivity theory imply about democracy? Holding productivity constant, democracy would tend to lower employment because it raises wages. However, there is a potential escape hatch (as there always is with neo-classical economics) in that one could argue democracy lowers the monopsony (buyer monopoly) power of employers, thereby raising both wages and employment.

The bottom line is there are two stories about the wage effects of democracy (and unions). 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 marginal productivity theory of income distribution you are either in or out with regard to the labor demand schedule, which tightly determines the relationship between wages and employment as a technological relationship. The neo-classical labor demand schedule is the essence of neo-classical economics, and most of its analysis collapses without it.

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, and only the neo-classical marginal productivity theory is taught as part of the core curriculum, while 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.

Here's the second edition:

Marginal Productivity Theory and the Mainstream  - 2^nd Edition, by Thomas I. Palley: [Author note: I am re-posting this article because I think the original did not hit its target cleanly. I have left the original posting on my website so that readers can judge for themselves. The edits to paragraph 11 are especially important]

Last week as part of a 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 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.