When paying more costs less
May 30th 1998
From The Economist print edition
Secretaries in investment banks tend to earn far more than secretaries in hotels. That is a puzzle for economists
TOP investment bankers earn telephone-number salaries. Even their junior colleagues earn fat pay-cheques. Presumably, that is because they make hefty profits for their bank. Why, though, are their secretaries paid more than secretaries elsewhere?
Just as rich and poor alike pay the same price for a pint of milk, so economic theory suggests that all firms should pay workers doing identical jobs the same wage. Yet that is not the case. Numerous studies, looking as far back as the 1920s, show that industries where profits and average productivity are higher tend to pay all their workers more. Thus American cleaners can earn over twice as much in law firms as in hotels. Mexican truck drivers who deliver oil take home much more than those who transport corn. British clerical workers make far more in the computer industry than in textiles. Broadly speaking, this wage gap can be explained in two ways: either the surveys are not comparing like with like; or highly profitable and productive companies may find it worthwhile for some reason to pay their employees more.
Some of the wage gap is no doubt due to measurement problems. Statisticians find it hard to distinguish between good secretaries and bad ones, and between unpleasant jobs and those with plenty of perks. So part of the reason why secretaries in investment banks are paid more may be that they are the more able ones, or that they have to cope with more pressure. But it is unlikely that measurement problems can explain the whole wage gap. The tendency for industries with high profits and productivity to pay all their staff well is so strong that it is hard to believe that their workers are better paid only because they are more talented in ways that surveys do not pick up.
Although ability is hard to measure, factors with which it is presumably correlatedsuch as age, education and tenureare not. Yet studies that control for those factors still come up with big wage disparities between industries. Moreover, although receptionists do not become less talented when they leave a bank to work in a hotel, their pay tends to drop in line with the wage gap between the two industries. And those who move the other way tend to get an equally big increase in pay. Surveys also show that well-paid workers tend to get morenot fewerfringe benefits. And high-wage industries tend to have lower staff turnover, which there would be no reason to expect if high wages merely compensated for unpleasant jobs.
Another explanation for the wage gap is that it may be profitable to pay workers more. Henry Ford famously claimed that his decision in 1914 to raisein some cases, more than doubleworkers basic pay to $5 a day was the finest cost-cutting move we ever made. Paying so-called efficiency wagesthe technical term for pay above the minimum level required to retain workersmay be profitable if it deters workers from slacking or spurs them to put in extra effort. Firms may also pay more than the going rate in order to attract talented staff and hang on to them.
The question, though, is why companies that are more productive and earn higher profits find it more worthwhile to pay over the odds than others. After all, a law firm does not need to spend more than a restaurant to find a new cleaner. Nor is it obvious why banks find it more costly than hotels to monitor how hard receptionists are working.
Economists have been exploring the efficiency-wage puzzle for 15 years or so, and the cost of monitoring workers performance has received considerable scrutiny. A new article* by Shailendra Raj Mehta of Purdue University, in Indiana, offers an interesting twist on the issue. In profitable and high-productivity industries, he argues, managers time is more valuable. It is therefore particularly costly for them to spend time monitoring employees. If such managers are to supervise their employees less, he says, workers need additional incentives to keep working hard. If an investment banker does not want to waste his precious time keeping tabs on his secretarys output, the easiest alternative is to pay her much more than she could earn in another job in order to motivate her to put in the effort.
Mr Mehta claims that this logic applies to cleaners too, because they are supervised by a manager at some level on the corporate ladder. That could help explain why firms increasingly find it cheaper to outsource cleaning work to service companies like Americas ServiceMaster or Britains Rentokil Initial. Because its line managers time is less valuable than a big banks, ServiceMaster can devote more managerial time to monitoring staff and therefore needs to pay them less of a premium than Microsoft or Coca-Cola might.
This is certainly not the only reason why more profitable firms pay all their workers more. Managers may feel that workers ought to share in the companys success. They may also want to boost their status by developing reputations for paying their subordinates well. There is also a question of fairness: if workers evaluate their wage package according to how well others at their firm are doing, they may become discontented if their own compensation seems to lag. If a bank makes huge profits and traders earn bumper bonuses, it may have to pay its clerical workers more in order to maintain their morale and prevent them from shirking.
You might expect, though, that profligate firms would be elbowed out by their more hard-nosed rivals. But not necessarily. Since clerical workers wages are only a small part of banks costs, paying them more may cost little, especially if it encourages more effort and loyalty. And if firms are profitable, they may have some market power and so may be able to afford some largesse. Moreover, since workers are aware that their high wages are a consequence of their companys profitability, they may have no problem taking pay cuts in lean times.
For all these reasons, workers doing the same job may often earn different wages. The key insight, though, is that when companies can afford to pay higher wages it may cost them little to do so.
The law of one price * and a theory of the firm: a Ricardian perspective on interindustry wages. RAND Journal of Economics. Spring 1998.