The Market Provides the Optimal Amount of Family Leave

Anyone who can pass an Econ 101 exam understands that if government were to mandate more paid family leave most workers would be made worse off.

The reason is that employers would respond to such a mandate by reducing the value of workers’ take-home pay (or of workers’ other fringe benefits, such as employer contributions to workers’ pension funds).

A mandate that forces employers to increase the portion of workers’ pay that takes the form of paid leave is a mandate that forces employers to decrease the portion of workers’ pay that takes the form of cash or of other fringe benefits.

And — as explained below — there being on offer no good reason to believe that markets generally undersupply paid leave, such a mandate would worsen workers’ pay packages: these packages would contain too much paid leave and too little take-home pay.

Aware that take-home pay will decrease if government simply mandates more paid leave, some conservatives — inexplicably mesmerized by the allegation that paid leave is undersupplied — propose an alternative means of increasing paid leave. This alternative means is to let workers themselves “buy” paid leave by borrowing against their Social Security accounts.

This “conservative plan” (we may call it) is likely better than a simple blanket mandate that employers offer more paid leave. An advantage of this conservative plan over government-mandated paid leave is that workers choose individually if and how much paid family leave to take. Workers who want such leave strongly enough to pay for it get such leave, while workers who do not want such leave aren’t obliged to “pay” for it in the form of lower wages.

What adverse selection?

But before examining the likely operation of the conservative plan to increase paid leave, it’s appropriate to ask why some conservatives believe that such a plan is necessary in the first place. Does the market really undersupply this fringe benefit?

Champions of the conservative plan, not surprisingly, answer “yes.”

Predictably, these conservatives assert that real-world labor markets are infected with “imperfect information” and “adverse selection” — tropes commonly chanted by economists whenever they wish to contrive a case for government intervention. Consider the argument made by American Enterprise Institute economist Aparna Mathur:

A classic market failure prevents many employers from offering an efficient level of paid leave on their own: adverse selection. If only a few firms offer paid leave, these firms will attract a disproportionate number of “high-risk” employees who are more likely to use the benefits (e.g., women of childbearing age). Employers at these firms might compensate for their larger share of high-cost employees by offering lower wages, leading individuals who are unlikely to use the benefits to avoid these firms. For this reason (and likely others), the implementation of paid leave policies at the employer level has been low.

In other words, most employers — in order to attract workers who value high wages relative to paid leave — won’t lower wages enough to make it profitable for them to offer more paid leave. Hence, the market supplies too little paid leave relative to take-home pay.

This argument, alas, “proves” too much. It can easily be reversed to demonstrate with equal likelihood that adverse selection causes employers to provide, not too little, but too much paid leave. Dr. Mathur could, with no less veracity, have alternatively written:

A classic market failure prevents many employers from offering an efficient level of take-home pay on their own: adverse selection. If only a few firms offer high take-home pay, these firms will attract a disproportionate number of “high-cost” employees who value high take-home pay relative to paid leave (e.g., women without plans to have children). Employers at these firms might compensate for their larger share of high-cost employees by offering lower amounts of paid leave, leading individuals who are unlikely to want as much take-home pay (relative to paid leave) to avoid these firms. For this reason (and likely others), the implementation of high-wage policies at the employer level has been low.

The result in this alternative formulation is that most employers — in order to attract workers who value paid leave relative to high wages — won’t reduce paid leave enough to make it profitable for them to offer higher wages. Hence, the market supplies too little take-home pay relative to paid leave.

The reasoning in this alternative tale of adverse selection — namely, how it leads to too much paid leave relative to take-home pay — is no less (and no more) sound than is the reasoning Dr. Mathur uses in her attempt to explain how adverse selection leads to too little paid leave relative to take-home pay. In each case a mere hypothetical is asserted; in neither case is there any reason to take the hypothetical seriously as a description of reality.

The case for government intervention surely requires a sturdier basis than the telling of a logically coherent, but empirically unsupported, tale of hypothetical market failure.

More Than One Pay Package Is Possible

A second flaw in Dr. Mathur’s argument is that her hypothetical ignores the possibility that employers will each offer to workers the option of choosing among different pay packages. If (as Dr. Mathur implicitly assumes) there is both a large number of workers who attach much value to paid family leave and a large number of workers who attach little value to such leave, many employers have incentives to attract workers from both groups by offering at least two pay packages of equal cost: Package A with no paid family leave but with higher take-home pay, and Package B with paid family leave but with lower take-home pay.

Offering workers such an option eliminates the adverse-selection problem described by Dr. Mathur.

Of course, not all employers will offer their workers these options. Sometimes the administrative (or “transaction”) costs of offering these options will exceed the benefits of doing so. But even if no employer offers its workers a choice between Package A and Package B, this situation does not imply that workers will not effectively have such a choice.

As Benjamin Zycher — also of AEI but no supporter of the paid-leave effort — notes in an email, firms can offer pay packages that differ from the offerings of other firms. Each worker will then sort himself or herself into a job with a firm whose pay package best suits him or her.

Thus, a third problem with Dr. Mathur’s adverse-selection saga is that she underestimates the market’s ability to customize pay packages across different firms.

Dr. Mathur can always reply that the costs incurred within each firm as well as across firms to customize pay packages are so high that adequate customization won’t occur and, hence, that too many workers will be stuck with suboptimal amounts of paid leave.

But here the burden (and it is a heavy one) falls upon her to explain both how these costs result in too little rather than too much paid leave, and also how government action to increase paid family leave will yield benefits in excess of costs.

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