I've been thinking a lot today about employee compensation. Yesterday's LA Times had a long article on Wal-Mart, the gist of which is that Wal-Mart's employees should be unionized and paid a lot more. One of the article's key points is that Wal-Mart's low pay has ripple effects, driving down the pay and benefits of unionized grocery store workers at Safeway and Albertson's. The subject came up again when I surfed over to CalPundit, where guest blogger Barbara Maynard, the chief spokesperson for UFCW Locals 770 and 1442, the grocery store unions on strike here in the Southland, asks:
Would you rather that these 70,000 middle class jobs become poverty level jobs filled by workers who have to turn to the taxpayer for healthcare and food stamps? That’s what the companies are proposing because that’s what Wal-Mart has. The CEOs of these three companies are just trying to keep up with the Waltons. Their combined operating profits have gone up 91% in the past five years...but Wal-Mart’s have gone up even more. Good lord — when is enough enough? At what price profits??? [Ed.: My emphasis]
I think unions serve important social and economic functions, as I've explained before, but when I hear actual union leaders talk I am reminded of an old Peanuts cartoon in which Linus says: "I love Mankind, its people I can't stand!" It's a lot easier to think positive thoughts about unions at the level of economic theory than when watching them work in practice.
Anyway, I was thinking about whether I wanted to write up Maynard's and CalPundit's comments, when I discovered a post by Rob at Business Pundit that provides a powerful answer to Maynard's question(to be clear, Rob's post didn't say anything about either the Times article or the CalPundit post):
What people don't accept is that some people make almost nothing while the company they work for makes a huge profit. The question seems to be that if a company is profitable, why should all the money go to the shareholders? Why not give some to the employees who are barely getting by? I think I have an answer to this, based on my own recent experience - the profits belong to those who take the risk, not those who do the work....
I am in the process of starting a company. ... I am the one who, by doing this, is on the hook for 300K if it fails. I am the one who may lose my house and file bankruptcy if it doesn't work. This could ruin my life. Why would I take such a risk? Because if things go well, I will have significantly more money than I do now. ... The people who will work for me aren't taking a risk. If we can't make it, they will simply move on to another job. They won't owe a bank huge sums of money, they won't have lost tens of thousands of dollars of their own hard-earned cash.
Gordon Smith at Venturpreneur followed up with a great post putting fleshing out Rob's framework with some economic theory:
Instead of asking who is entitled to the profits, let's ask who is most likely to maximize profits? (After all, from a societal standpoint, maximizing the residual claim maximizes value creation, and we generally like value creation.) On the one hand, anyone who has a claim to the profits will want to maximize them. On the other hand, the only person who has a chance of success is the person who controls the firm. Here is a kernel of insight: profits attach to residual control. ...
Well, maybe I failed to mention that people can exercise residual control only by "purchasing" the right (not necessarily from another person, but by exposing oneself to substantial personal loss). This is where the notion of risk comes into the picture. If control were cheap, everyone would want it (which, of course, would cause the price rise ... so that was a silly game, wasn't it?). Residual control is expensive relative to other forms of participation in the firm.
Requiring entrepreneurs to take this step of puchasing residual control acts as a defense against adverse selection: people who know that they have limited competence would not be willing to purchase residual control because the costs of failure are too high.
As I explained in my article, In Defense of the Shareholder Wealth Maximization Norm, maximizing the value of the residual claim is just as important for established public companies as it is for the startups Rob and Gordon are discussing. In sum, Ms. Maynard is asking the wrong question. It's not "at what price profit" but "at what price not making a profit?" Take away the profit motivation and Ms. Maynard's union members won't be dealing with higher health benefit costs, they'll be out of a job.
Update: I want to quibble with one point Rob made. Rob wrote:
The people who will work for me aren't taking a risk. If we can't make it, they will simply move on to another job. They won't owe a bank huge sums of money, they won't have lost tens of thousands of dollars of their own hard-earned cash.
Rob’s argument only works with respect to employees whose jobs do not require investments in firm specific human capital, because employees who do make such investments fairly can be said to be taking an entrepreneurial-like risk.
Consider an employee who invests considerable time and effort in learning how to do his job more effectively. Much of this knowledge will be specific to the firm for which he works. The effort and opportunity costs incurred in developing such knowledge constitute an investment in firm specific human capital upon which the employee can earn a return only so long as he remains with that firm.
A rational employee will invest in firm-specific human capital only if rewarded for doing so. An implicit contract thus comes into existence between the employee and the firm. On the one hand, employees promise to become more productive by investing in firm-specific human capital. They bond the performance of that promise by accepting long promotion ladders and compensation schemes that defer much of the return on their investment until the final years of their career. Accepting deferred compensation, in which salary or wages rises with seniority, provides such a bond because the employee will carry out his side of the bargain in order to avoid being terminated before compensation rates rise at the end of his career. In return, the firm promises to fulfill its part of the bargain by providing job security so that the employee will be able to collect that deferred compensation. This bargain exposes the employee to firm specific risk. If the firm fails, their investment will be lost. If the firm behaves opportunistically, such as by terminating older employees, again their investment will be lost. These employees thus are taking an entrepreneurial-like risk. They can't just "simply move on to another job," as their investment has created a bilateral monopoly. As for Rob's employees, however, I gather that Rob will be helping his employees develop their general human capital to a higher level, rather than requiring them to develop human capital that is specific to your firm, in which case he is quite right that they are not taking entrepreneurial-like risk.
As for employees who do invest in firm specific human capital, do such employees have a “right” to a share in firm profits? Of course not. As an economic matter, however, failing to provide such employees with credible prote ctions for their investments in firm specific human capital will significantly increase labor costs and/or reduce firm productivity. Firms that want to encourage such investments will find a variety of ways of providing the requisite assurances. Promotion ladders with ports of entry, profit-sharing, seniority systems, and the like are all options.
From a management perspective, an entrepreneur needs to figure out whether his new business will require employees with general or firm specific human capital. In many front-line industries, skills evolve so rapidly that the skills of even quite young employees become obsolete and are replaced by still younger workers. This has led to a situation in which the old implicit contract between workers and companies, in which workers traded loyalty for job security, is virtually dead. Instead, the labor relationship is increasingly viewed as temporary by both sides. Job mobility is increasingly more common than job security. In such an environment, workers need – and are more likely to develop – general human capital rather than firm specific human capital. Figuring out which type of employees you need is a key management decision for any entrepreneur.
