The labour market, along with finance/banking and development, is one of the areas where neoclassical theory has proven to be most off the mark. Although more advanced models of the labour market try to address some of the flaws in MVP theory, they generally do this by adding ‘frictions’ such as heterogeneity and job search problems. The general premise – as with much of neoclassical economics- is that without these ‘frictions’, the labour market would operate as described in the textbooks. But this is not true.
Production, by definition, requires that all the factors of production be brought together. As a result, labour is employed at the same time as capital (and land, but we can lump the two together for the purposes of this post) in every circumstance. A taxi driver without his taxi is worthless, and vice-versa. Adding an extra worker to an office necessitates an extra computer, desk and stationary. Adding another builder to a site necessitates tools. Hence any ‘marginal productivity’ can only be applied to the labour and capital as a whole (what Ricardo called a ‘bushel’).
Not only this, but the Division of Labour (DoL) means that it is often impossible to separate the produce of one worker from that of his colleagues. A construction site requires carpenters, plumbers, bricklayers, supervisors, semi-skilled labourers, labourers and many more. But what if you remove only the carpenter? You wouldn’t be able to construct the house. But it would be incoherent to claim his MVP were an entire house – you can only evaluate the product of the entire team together, including their capital. So the marginalist approach makes absolutely no sense, particularly in a society where the DoL spans global borders.
This is also a prime example of an area where historical context in teaching would be appropriate, for the fact is that John Bates Clark created his ‘Marginal Value Product’ theory – the reasoning for which is entirely circular – at the turn of the century, a time of unrest among the working classes, in order to try and settle them. Basically, it was a justification for the status quo: you are paid what you are worth, sorry that isn’t as much as you thought. This context is strangely absent in economics classes, though surely its presence would lead students to ask some questions.
Given that the only coherent way to think of produce is as a result of all of the factors of production combined, what determines each factor of production’s share of the produce? Each wants as much as possible, but each requires the others in order to gain any produce at all. So the share for one factor of production is determined by its relative ability to replace the other factors of production. Or, to put it another way, the produce is distributed by bargaining power. In absence of government, capital, being scarcer, generally holds this, and hence receives higher returns. History also suggests that when capital finds itself in a position where this isn’t true, it will use government apparatus to correct this injustice (increasing interest rates, busting unions).
The empirical failure of the standard theory with respect to the minimum wage is well documented*. Furthermore, employment was generally higher during the post-WW2 age of rising real wages and strong unions, and has been lower post 1980, the age of stagnant real wages and weak unions. This doesn’t suggest a causal link, but it does show that high employment is not incompatible with higher wages, and, along with Card-Krueger and the outright logical inconsistency of the MVP theory, makes me inclined to align with the bargaining power story.
*I’m aware that Card and Krueger do not adopt a classical bargaining power perspective, but their evidence still corroborates with it.