Mankiw Principles of Economics (3rd ed)

the United States tends to import goods produced with unskilled labor and export goods produced with skilled labor. Thus, when international trade expands, the domestic demand for skilled labor rises, and the domestic demand for unskilled labor falls.

The second hypothesis is that changes in technology have altered the relative demand for skilled and unskilled labor. Consider, for instance, the introduction of computers. Computers raise the demand for skilled workers who can use the new machines and reduce the demand for the unskilled workers whose jobs are replaced by the computers. For example, many companies now rely more on computer databases, and less on filing cabinets, to keep business records. This change raises the demand for computer programmers and reduces the demand for filing clerks. Thus, as more firms begin to use computers, the demand for skilled labor rises, and the demand for unskilled labor falls.

Economists have found it difficult to gauge the validity of these two hypotheses. It is possible, of course, that both are true: Increasing international trade and technological change may share responsibility for the increasing inequality we have observed in recent decades.

ABILITY, EFFORT, AND CHANCE

Why do major league baseball players get paid more than minor league players? Certainly, the higher wage is not a compensating differential. Playing in the major leagues is not a less pleasant task than playing in the minor leagues; in fact, the opposite is true. The major leagues do not require more years of schooling or more experience. To a large extent, players in the major leagues earn more just because they have greater natural ability.

Natural ability is important for workers in all occupations. Because of heredity and upbringing, people differ in their physical and mental attributes. Some people are strong, others weak. Some people are smart, others less so. Some people are outgoing, others awkward in social situations. These and many other personal characteristics determine how productive workers are and, therefore, play a role in determining the wages they earn.

Closely related to ability is effort. Some people work hard; others are lazy. We should not be surprised to find that those who work hard are more productive and earn higher wages. To some extent, firms reward workers directly by paying people on the basis of what they produce. Salespeople, for instance, are often paid as a percentage of the sales they make. At other times, hard work is rewarded less directly in the form of a higher annual salary or a bonus.

Chance also plays a role in determining wages. If a person attended a trade school to learn how to repair televisions with vacuum tubes and then found this skill made obsolete by the invention of solid-state electronics, he or she would end up earning a low wage compared to others with similar years of training. The low wage of this worker is due to chance—a phenomenon that economists recognize but do not shed much light on.

How important are ability, effort, and chance in determining wages? It is hard to say, because ability, effort, and chance are hard to measure. But indirect evidence suggests that they are very important. When labor economists study wages, they relate a worker’s wage to those variables that can be measured—years of schooling, years of experience, age, and job characteristics. Although all of these

view, when people earn a college degree, for instance, they do not become more productive, but they do signal their high ability to prospective employers. Because it is easier for high-ability people to earn a college degree than it is for low-ability people, more high-ability people get college degrees. As a result, it is rational for firms to interpret a college degree as a signal of ability.

The signaling theory of education is similar to the signaling theory of advertising discussed in Chapter 17. In the signaling theory of advertising, the advertisement itself contains no real information, but the firm signals the quality of its product to consumers by its willingness to spend money on advertising. In the signaling theory of education, schooling has no real productivity benefit, but the worker signals his innate productivity to employers by his willingness to spend years at school. In both cases, an action is being taken not for its intrinsic benefit but because the willingness to take that action conveys private information to someone observing it.

Thus, we now have two views of education: the human-capital theory and the signaling theory. Both views can explain why more educated workers tend to earn more than less educated workers. According to the human-capital view, education makes workers more productive; according to the signaling view, education is correlated with natural ability. But the two views have radically different predictions for the effects of policies that aim to increase educational attainment. According to the human-capital view, increasing educational levels for all workers would raise all workers’ productivity and thereby their wages. According to the signaling view, education does not enhance productivity, so raising all workers’ educational levels would not affect wages.

Most likely, truth lies somewhere between these two extremes. The benefits to education are probably a combination of the productivity-enhancing effects of human capital and the productivity-revealing effects of signaling. The open question is the relative size of these two effects.

CASE STUDY HUMAN CAPITAL, NATURAL ABILITY, AND

COMPULSORY SCHOOL ATTENDANCE

Does attending school increase wages because it increases productivity, or does it only appear to increase productivity because high-ability people are more likely to stay in school? This question is important both for judging the various theories of education and for evaluating alternative education policies.

If economists could conduct controlled experiments like laboratory scientists, it would be easy to answer this question. We could choose some experimental subjects from the school-age population and then randomly divide them into various groups. For each group we could require a different amount of school attendance. By comparing the difference in the educational attainment and the difference in subsequent wages of the various groups, we could see whether education does in fact increase productivity. Because the groups would be chosen randomly, we could be sure that the difference in wages was not attributable to a difference in natural ability.

Although conducting such an experiment might seem difficult, the laws of the United States inadvertently provide a natural experiment that is quite similar. All students in the United States are required by law to attend school, but the laws vary from state to state. Some states allow students to drop out at age

16, while others require attendance until age 17 or 18. Moreover, the laws have changed over time. Between 1970 and 1980, for instance, Wyoming reduced the school-attendance age from 17 to 16, while Washington raised it from 16 to 18. This variation across states and over time provides data with which to study the effects of compulsory school attendance.

Even within a state, school-attendance laws have different effects on different people. Students start attending school at different ages, depending on the month of the year in which they were born. Yet all students can drop out as soon as they reach the minimum legal age; they are not required to finish out the school year. As a result, those who start school at a relatively young age are required to spend more time in school than those who start school at a relatively old age. This variation across students within a state also provides a way to study the effects of compulsory attendance.

In an article published in the November 1991 issue of the Quarterly Journal of Economics, labor economists Joshua Angrist and Alan Krueger used this natural experiment to study the relationship between schooling and wages. Because the duration of each student’s compulsory schooling depends on his or her state of residence and month of birth, and not on natural ability, it was possible to isolate the productivity-enhancing effect of education from the ability-signaling effect. According to Angrist and Krueger’s research, those students who were required to finish more school did earn significantly higher subsequent wages than those with lower requirements. This finding indicates that education does raise a worker’s productivity, as the human-capital theory suggests.

Although establishing the benefits of compulsory schooling is useful, it does not by itself tell us whether these laws are desirable. That policy judgment requires a more complete analysis of the costs and benefits. At the very least, we would need to compare the benefits of schooling to the opportunity cost—the wages that the student could have earned by dropping out. In addition, requiring a student to stay in school may have external effects on others in society. On the one hand, compulsory school attendance may reduce crime rates, for young dropouts are at high risk of engaging in criminal activity. On the other hand, students who stay in school only because they are required to do so may interfere with the learning of other students who are more committed to their educations.

THE SUPERSTAR PHENOMENON

Although most actors earn very little and often have to take jobs as waiters to support themselves, actor Robin Williams earned $23 million in 1997. Similarly, although most people who play football do it for free as a hobby, Brett Favre earned $6.75 million as a pro quarterback. Robin Williams and Brett Favre are superstars in their fields, and their great public appeal is reflected in astronomical incomes.

Why do Robin Williams and Brett Favre earn so much? It is not surprising that there are differences in incomes within occupations. Good carpenters earn more than mediocre carpenters, and good plumbers earn more than mediocre plumbers. People vary in ability and effort, and these differences lead to differences in income. Yet the best carpenters and plumbers do not earn the many millions that are common among the best actors and athletes. What explains the difference?

To understand the tremendous incomes of Robin Williams and Brett Favre, we must examine the special features of the markets in which they sell their services. Superstars arise in markets that have two characteristics:

In fact, human capital is probably even more important in explaining wage differentials than the foregoing numbers suggest. For many years, public schools in predominantly black areas have been of lower quality—as measured by expenditure, class size, and so on—than public schools in predominantly white areas. Similarly, for many years, schools directed girls away from science and math courses, even though these subjects may have had greater value in the marketplace than some of the alternatives. If we could measure the quality as well as the quantity of education, the differences in human capital among these groups would seem even larger.

Human capital acquired in the form of job experience can also help explain wage differences. In particular, women tend to have less job experience on average than men. One reason is that female labor-force participation has increased over the past several decades. Because of this historic change, the average female worker today is younger than the average male worker. In addition, women are more likely to interrupt their careers to raise children. For both reasons, the experience of the average female worker is less than the experience of the average male worker.

Yet another source of wage differences is compensating differentials. Some analysts have suggested that women take more pleasant jobs on average than men and that this fact explains some of the earnings differential between men and women. For example, women are more likely to be secretaries, and men are more likely to be truck drivers. The relative wages of secretaries and truck drivers depend in part on the working conditions of each job. Because these nonmonetary aspects are hard to measure, it is difficult to gauge the practical importance of compensating differentials in explaining the wage differences that we observe.

In the end, the study of wage differences among groups does not establish any clear conclusion about the prevalence of discrimination in U.S. labor markets. Most economists believe that some of the observed wage differentials are attributable to discrimination, but there is no consensus about how much. The only conclusion about which economists are in consensus is a negative one: Because the differences in average wages among groups in part reflect differences in human capital and job characteristics, they do not by themselves say anything about how much discrimination there is in the labor market.

Of course, differences in human capital among groups of workers may themselves reflect discrimination. The inferior schools historically available to black students, for instance, may be traced to prejudice on the part of city councils and school boards. But this kind of discrimination occurs long before the worker enters the labor market. In this case, the disease is political, even if the symptom is economic.

DISCRIMINATION BY EMPLOYERS

Let’s now turn from measurement to the economic forces that lie behind discrimination in labor markets. If one group in society receives a lower wage than another group, even after controlling for human capital and job characteristics, who is to blame for this differential?

The answer is not obvious. It might seem natural to blame employers for discriminatory wage differences. After all, employers make the hiring decisions that determine labor demand and wages. If some groups of workers earn lower wages than they should, then it seems that employers are responsible. Yet many economists are

skeptical of this easy answer. They believe that competitive, market economies provide a natural antidote to employer discrimination. That antidote is called the profit motive.

Imagine an economy in which workers are differentiated by their hair color. Blondes and brunettes have the same skills, experience, and work ethic. Yet, because of discrimination, employers prefer not to hire workers with blonde hair. Thus, the demand for blondes is lower than it otherwise would be. As a result, blondes earn a lower wage than brunettes.

How long can this wage differential persist? In this economy, there is an easy way for a firm to beat out its competitors: It can hire blonde workers. By hiring blondes, a firm pays lower wages and thus has lower costs than firms that hire brunettes. Over time, more and more “blonde” firms enter the market to take advantage of this cost advantage. The existing “brunette” firms have higher costs and, therefore, begin to lose money when faced with the new competitors. These losses induce the brunette firms to go out of business. Eventually, the entry of blonde firms and the exit of brunette firms cause the demand for blonde workers to rise and the demand for brunette workers to fall. This process continues until the wage differential disappears.

Put simply, business owners who care only about making money are at an advantage when competing against those who also care about discriminating. As a result, firms that do not discriminate tend to replace those that do. In this way, competitive markets have a natural remedy for employer discrimination.

CASE STUDY SEGREGATED STREETCARS AND

THE PROFIT MOTIVE

In the early twentieth century, streetcars in many southern cities were segregated by race. White passengers sat in the front of the streetcars, and black passengers sat in the back. What do you suppose caused and maintained this discriminatory practice? And how was this practice viewed by the firms that ran the streetcars?

In a 1986 article in the Journal of Economic History, economic historian Jennifer Roback looked at these questions. Roback found that the segregation of races on streetcars was the result of laws that required such segregation. Before these laws were passed, racial discrimination in seating was rare. It was far more common to segregate smokers and nonsmokers.

Moreover, the firms that ran the streetcars often opposed the laws requiring racial segregation. Providing separate seating for different races raised the firms’ costs and reduced their profit. One railroad company manager complained to the city council that, under the segregation laws, “the company has to haul around a good deal of empty space.”

Here is how Roback describes the situation in one southern city:

The railroad company did not initiate the segregation policy and was not at all eager to abide by it. State legislation, public agitation, and a threat to arrest the president of the railroad were all required to induce them to separate the races on their cars. . . . There is no indication that the management was motivated by belief in civil rights or racial equality. The evidence indicates their primary motives were economic; separation was

costly. . . . Officials of the company may or may not have disliked blacks, but they were not willing to forgo the profits necessary to indulge such prejudice.

The story of southern streetcars illustrates a general lesson: Business owners are usually more interested in making profit than in discriminating against a particular group. When firms engage in discriminatory practices, the ultimate source of the discrimination often lies not with the firms themselves but elsewhere. In this particular case, the streetcar companies segregated whites and blacks because discriminatory laws, which the companies opposed, required them to do so.

DISCRIMINATION BY CUSTOMERS AND GOVERNMENTS

Although the profit motive is a strong force acting to eliminate discriminatory wage differentials, there are limits to its corrective abilities. Here we consider two of the most important limits: customer preferences and government policies.

To see how customer preferences for discrimination can affect wages, consider again our imaginary economy with blondes and brunettes. Suppose that restaurant owners discriminate against blondes when hiring waiters. As a result, blonde waiters earn lower wages than brunette waiters. In this case, a restaurant could open up with blonde waiters and charge lower prices. If customers only cared about the quality and price of their meals, the discriminatory firms would be driven out of business, and the wage differential would disappear.

On the other hand, it is possible that customers prefer being served by brunette waiters. If this preference for discrimination is strong, the entry of blonde restaurants need not succeed in eliminating the wage differential between brunettes and blondes. That is, if customers have discriminatory preferences, a competitive market is consistent with a discriminatory wage differential. An economy with such discrimination would contain two types of restaurants. Blonde restaurants hire blondes, have lower costs, and charge lower prices. Brunette restaurants hire brunettes, have higher costs, and charge higher prices. Customers who did not care about the hair color of their waiters would be attracted to the lower prices at the blonde restaurants. Bigoted customers would go to the brunette restaurants. They would pay for their discriminatory preference in the form of higher prices.

Another way for discrimination to persist in competitive markets is for the government to mandate discriminatory practices. If, for instance, the government passed a law stating that blondes could wash dishes in restaurants but could not work as waiters, then a wage differential could persist in a competitive market. The example of segregated streetcars in the foregoing case study is one example of government-mandated discrimination. More recently, before South Africa abandoned its system of apartheid, blacks were prohibited from working in some jobs. Discriminatory governments pass such laws to suppress the normal equalizing force of free and competitive markets.

To sum up: Competitive markets contain a natural remedy for employer discrimination. The entry of firms that care only about profit tends to eliminate discriminatory wage differentials. These wage differentials persist in competitive markets only when customers are willing to pay to maintain the discriminatory practice or when the government mandates it.