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Economic Naturalist Question # 11. Why are the least productive workers in a firm typically paid more than the value of what they produce, while the most productive workers are paid less? 
In an earlier thread, I explored why introductory economics courses appear to leave little lasting imprint on the millions of students who take them each year:
Students learn more effectively when they pose interesting questions based on personal experience, and then use basic economic principles to help answer them. This exercise became what I call my “economic naturalist” writing assignment.
The theory of competitive labor markets suggests that workers will be paid in accordance with the value of what they add to their employer’s bottom line. Yet in most organizations, the contributions of workers doing similar work vary much more than the wages they are paid.
For instance, if Smith and Jones are carpenters and Smith contributes $35/hr to his employer’s bottom line while Jones contributes only $5/hr, theory predicts that the two would be paid $35/hr and $5/hr, respectively.
In practice however, observed wages differ much less than observed productivity differences. Smith might be paid only $25/hr, for example, while Jones might be paid $15/hr.
More generally, the top-ranked workers within a group are paid less in proportion to what they contribute, while the bottom-ranked workers are paid more. This seems like a good deal for the bottom-ranked workers!
But this pattern seems to imply cash on the table. If Smith is worth $35/hr and is being paid only $25/hr, then a rival firm could pocket a quick $5/hr in extra profits by luring him away at a salary of $30/hr.
But this would still leave cash on the table for other rival firms. So Smith’s salary should be quickly bid up to $35/hr, since that’s the value of what he contributes. Yet that generally doesn’t happen.
A possible explanation begins with the assumption that most workers would prefer to occupy high-ranked positions in their work groups rather than low-ranked ones.
The problem is that not every worker’s preference for a high-ranked position can be satisfied within any given work group. After all, 50 percent of the positions in a group must always be in the bottom half.
So the only way some workers are able to enjoy the satisfaction inherent in positions of high rank is if others are willing to endure the dissatisfactions associated with low rank.
If workers cannot be forced to remain with an organization against their wishes, the low-ranked workers will find it attractive to remain only if they receive additional compensation.
Where does this extra compensation come from? It appears to be financed by an implicit tax on the earnings of their high-ranked coworkers.
If the tax isn’t too high, the high-ranked workers are happy to remain with the firm, even though they could earn more elsewhere, and the low-ranked workers find the extra pay sufficient to compensate for the burdens of low rank.
The resulting pay pattern within each firm is the functional equivalent of a progressive income tax.
In many occupations, individuals face a menu of job choices in different firms. Those who don’t care much about having high local rank do best by accepting low-ranked positions at premium pay in firms with highly productive employees—a position like C in Firm 1 in the diagram.
Those who value high local rank most do best by accepting high-ranked positions at lower pay in firms with lower average productivity—a position like A at Firm 3. Those who assign intermediate value to having high local rank are more likely to choose a position like B at firm 3.
In effect, there appears to be an implicit market for local status within firms.
The resulting pay compression is both efficient and fair. Why should some people enjoy the value of high local rank for free? And why should others be forced to endure the costs of low local rank without compensation?
