Bryan Caplan  

Why Do Firms Prefer More Able Workers?

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Academics habitually tax the public's patience with stupid questions.  It's easy to see why practical folk ignore us.  Every now and then, though, an academic asks a truly profound question that seems stupid on the surface.  Case in point: David Romer's still unpublished 1992 paper "Why Do Firms Prefer More Able Workers?," newly available on my website with his kind permission.

What on earth could be puzzling about the fact that firms prefer more able workers?  Well, if firms pay everyone what they're worth, then hiring the most-able is no more profitable than hiring the least-able.  As Romer explains:
In most markets, prices rise with general quality so that buyers have optimal levels of quality.  In the automobile market, for example, a typical buyer identifies some target level or range of general quality and then searches for cars within that general category... The cost of a car rises essentially one-for-one with its general quality, and thus there is no reason to expect the highest quality cars to generate the most surplus for a buyer; rather, large surplus is generated when a buyer is able to find a car that fits his or her particular needs and tastes well.

This account does not appear to describe what occurs in the labor market.  Consider a firm that is attempting to fill a position.  There will generally be a variety of applicants, and they will typically differ in terms of observable characteristics that are relevant to likely performance on the job - education, experience, punctuality, articulateness, and so on.  In most circumstances, the firm does not have some target level of ability; rather, faced with a variety of applicants who are interested in the position, it offers the position to the most able.  Equivalently, typically the workers that a firm would least like to lose are its most able.  Personnel management texts and hiring and interviewing guides, for example, simply take it as given that the goal of the hiring process is to find the most talented possible worker.
After putting the puzzle on the table, Romer offers an elegant solution: Firms prefer more able workers because pay is more equal than productivity.  Why?  Because inequality hurts morale of lower-paid workers.  After presenting a mathematical model to show that his story is internally consistent, Romer discusses empirical evidence in favor of his story.  He starts by surveying "observers of the labor market":
Consider for example the evidence provided by the authors of personnel management textbooks.  An important message of such textbooks is that it is the effort of low-ability workers than is most easily affected by pay policies.  Fairness and rewarding ability and accomplishment are generally viewed as distinct functions of a pay system...

The authors of such books simply presume that compensation should (and does) rise less than one-for-one with workers' contributions, and that the only question is to what extent pay should be related to performance.
Then he covers experimental evidence showing that:
...when experimental subjects are asked to allocate rewards among participants in a project to promote harmony and minimize conflict, they reduce the dispersion in the rewards.  Such reallocations make sense only if notions of fairness involve an element of absolute equality rather than simply rewards proportional to contributions.
Finally, Romer points out a bunch of odd facts that his model readily explains:
  • Pay compression.
  • Pay secrecy.
  • Unions simultaneously make compensation more open and more compressed.
  • Why some firms and industries pay higher wages to all their workers.

Empirical work on the last point is intriguing.  Romer:

Dickens and Katz (1987a) find that one of the variables most strongly associated with inter-industry wage differences is the average education level of workers in the industry; that is, a given worker on average earns a higher wage in an industry where his or her fellow workers have greater education.  This is precisely in accord with the prediction of the theory that a worker of any given ability level obtains a higher wage in a firm where average ability levels are higher.  Dickens and Katz find that industry wage differences are moderately associated with other worker characteristics associated with higher wages, notably average experience and tenure and the fraction of workers who are male.

Also check out Romer's explanation for large firms' tendency to pay all their workers more.

Overall, a profound paper.  I'm not quite ready to say "Read the whole thing"; pondering the mathematical sections equation-by-equation could easily take all day.  But I will say "Read all the English."  You won't just learn important lessons about labor economics.  You'll also learn the meta-lesson that the distinguishing between banal and profound questions is harder than it looks.



COMMENTS (13 to date)
Glen S. McGhee writes:

I can see why Romer never published this.

I don't think he understands hiring process, whereas Lauren Rivera does.

Hiring as Cultural Matching: The Case of Elite Professional Service Firms
Lauren A. Rivera

http://w.asanet.org/journals/ASR/Dec12ASRFeature.pdf

and another Rivera paper:
Cultural Reproduction in the Labor Market: Homophily in Hiring

Bryan, you've used Rivera before on screening, why the change?

Orfeu writes:
Bryan, you've used Rivera before on screening, why the change

It has to do with that book about why employers don't lower wages during a recession. It has the same info in it.

Mr. Econotarian writes:

Something does not ring true here. I've often been involved in hiring decisions where we do not hire the "most able" worker because we can't afford the "most able" worker for the limited tasks of the position. Or even if the economy is bad and a more able & experienced worker would take our target wage, we know that they would simply start looking for a higher paid position when the economy got better.

Hiring is like buying a car. Sometimes your are looking for some Ford Trucks or Kias, and occasionally you need to pay more for a Ferrari.

The big difference is that sometimes you hire someone for a particular position, but you are making a gamble that they will grow into a "more able" worker over time for better positions within your company (while maintaining internal knowledge), you don't expect your Ford Truck to turn into a Ferrari, but sometimes workers do, so you may hire an intelligent worker who communicates well but has little formal training in your industry and hope they learn what is required on the job.

Glen Smith writes:

In the strict economic sense, almost no firm prefers the more able worker. I guess if preference here is the more broad meaning of preference used conversationally, it may be a true statement. It might also depend on what you mean by the phrase "most able worker" though to most people it seems simply to mean the worker that is best able to meet the technical requirements.

honeyoak writes:

As an HR consultant, I have also experienced when firms specifically hire non-productive workers because it maximizes the rents of the incumbent managers.

Hazel Meade writes:

DO firms really prefer more able workers?

What about overqualification?

john hare writes:

More able workers produce far less mistakes. A $20.00 an hour man has a job worth protecting, while his $8.00 an hour helper doesn't. In construction, anyone that will work for minimum wage is a liability, with a few exceptions.

MingoV writes:

I directed medical laboratories. When hiring for a position, we looked at our needs. Did we want someone who would stay in the position for years, or did we want someone interested in promotion and advancement? In both cases we needed someone with adequate skills: we wouldn't hire a ham-handed phlebotomist who couldn't hit a vein. When I directed a large lab at an academic medical center, we tended to choose qualified people who hoped to advance. We even chose people who would advance to positions outside the lab. (We had one phlebotomist who became a physician assistant school and another who became a pharmacist.)

Why would we train an employee who would move on or move away in a year or two? Answer 1: We always got the best applicants in the region. Our reputation of encouraging and helping employees advance was a huge plus in a market with more unfilled positions than applicants. Answer 2: Employee morale was very high. Answer 3: Employees who left for more training (eg: phlebotomist to med tech school) often returned to fill an opening for a more advanced position. Answer 4: We were an academic medical center, and we felt that supporting career advancement was part of our mission.

When I was at a small private lab, our priorities differed. We wanted people who would stay in a position for years. These generally were not they best qualified applicants, though they had sufficient skills.

Chris Thomas writes:

It seems worth pointing out that firms often DON'T want more able workers. Anyone who has hiring experience should know this. The very phrase "over qualified" is a common English term, and everyone knows what it means. In my experience, managers often refuse to consider people for just this reason. Now this is clearly only part of the story, and firms also prefer more able workers; I just wonder if this phenomenon gets discussed at all in the paper.

Michael Stack writes:

I've long thought that hiring "the best" had a lot to do with communication costs and productivity variances, though this observation may be specific to the software industry.

In a software project, communication/coordination costs grow as the square of the number of developers on a project, so you'd prefer 2 or 3 really gifted developers instead of 10 average developers, even if on paper, the 10 average developers can produce more code (holding quality constant). The minimization of coordination costs swamp whatever you may have saved in labor costs with the lesser developers.

Additionally, software developers have huge productivity variances. If I recall correctly it is nearly an order of magnitude of difference in productivity between the most and least productive.

This also introduces a bit of a puzzle. Given the productivity variances (and assuming my 'order of magnitude' variance estimate is correct), you'd expect equally large variances in developer compensation, but experience shows me this is not the case.

All this said, I think the explanation given in the paper does a much better job of explaining many of the puzzles around the preference for talented workers.

Anonymous writes:
In the automobile market, for example, a typical buyer identifies some target level or range of general quality and then searches for cars within that general category... The cost of a car rises essentially one-for-one with its general quality, and thus there is no reason to expect the highest quality cars to generate the most surplus for a buyer; rather, large surplus is generated when a buyer is able to find a car that fits his or her particular needs and tastes well.
Say what? Romer seems to live in some bizzaro world (academia?). That's not how I shop for a car at all. What I do, ceteris paribus*, is identify a target price range, not a quality range, then search for the highest quality within that price range. Surplus is "generated" because the dealership set the price too low...too low in the sense that I would have been willing to pay more.

*Obviously, "feature fit" matters as well, but you have to control for that since what's being explored is why firms choose a particular quality.


This account does not appear to describe what occurs in the labor market.
I have a small business. It pretty much exactly describes what occurs when I hire somebody.


There will generally be a variety of applicants, and they will typically differ in terms of observable characteristics that are relevant to likely performance on the job - education, experience, punctuality, articulateness, and so on. In most circumstances, the firm does not have some target level of ability; rather, faced with a variety of applicants who are interested in the position, it offers the position to the most able.
Ummmm....no. What I do, again, is decide on a target price first. That's why I put a pay rate in the ad. Then I look for the best applicant at that price.

In some positions the salary will be negotiated later, but the same general principle is at work. If the applicant's demands are too high, we won't reach an agreement, and the applicant will turn down the position. That's certainly not a case where the firm hiring the "most able" applicant, as Romer claims, is it?


This part really got me...

The cost of a car rises essentially one-for-one with its general quality
Are you people professional economists? A BMW might cost twice as much as a Toyota but it certainly isn't twice the quality. Clearly the quality increases have diminishing returns as the price rises. Look at the extremes. There's a reason why $10 million cars don't exist, even though there are certainly many people out there who could afford a $10 million car. But a $10 million car is probably no better than a $1 million car, as the returns have diminished to nil.


It's pretty obvious that Romer is reaching to justify his egalitarian values, and making ridiculously bad arguments to do so. I expect that's commonplace among left-wing economists, but to see somebody like Brian praising it as profound? Embarrassing.

But maybe you have discovered something. Perhaps THIS is why people don't like academics...you flash your credentials like it makes you creditworthy, even though you're no more intellectually honest than anybody else. Then you stamp your feet and snub your noses at everybody else when they don't listen to you.

Thomas Sewell writes:

Taking this as a given (which it isn't necessarily 100%, but I think there is at least some truth to the idea that abler workers aren't typically compensated in proportion to their ability), it would also imply that a large source of entrepreneurs would be more able people seeking a way to capture the true value of their abilities in the market.

In the same manner, the franchise model of McDonald's, etc... is based on being able to attract the more able by making them a franchisee who is compensated based on the ability and performance more accurately than it they were an employee.

That in turn makes me think that in the future, as we see more independent contracting, working remotely, etc... those with higher ability should be able to command a higher percentage of the compensation using similar models.

Rachel writes:

The value of marginal productivity is at least partly responsible for why the "most able" candidate is not always hired. If the most able worker is also the most expensive, the marginal value of productivity that he/she produces is still the most important factor economically, when making a decision to hire. Will that extra $12 dollars per hour spent on the salary of the more able worker pay off? And let's not forget those jobs that hire at a fixed rate. When hiring someone for a union job, or a minimum wage job, or a government job, or any other job that has a fixed starting salary, of course you hire the most able worker, assuming you can perfectly detect who that is, because you are getting more production for the same price. Also, as the HR and hiring managers well know, the decision to hire a worker who is blatantly not qualified for a role involves actually changing the position for which that person is being hired. An interesting question to me is what does decision to choose cheap, inexperienced labor instead of more expensive, more able labor tell us about the hiring firms/ sectors and labor force? That choice to change from initially looking to hire expensive/experienced workers to instead looking for cheap/inexperienced workers. Other than a change in technology, that could make an industry's production more capital intensive...

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