Temp Agencies and Employer Learning

Paging Bryan Caplan.

In this episode of Econtalk featuring Noah Smith, Russ Roberts brings up the topic of temp agencies. Why, Roberts asks, do temp agencies command such a high premium? They take a large fraction of their workers' hourly wages. Why should temporary workers be willing to pay such a premium to someone to find them work? (This is particularly baffling when you consider that these are people with already-low wages.) Both Noah and Russ seem confused and don't have an easy answer, but some commenters present plausible explanations.

From a listener called MF:

Towards the end of the conversation, Russ and Noah talk about the role of temp agencies in employment.

My company (A small manufacturer, just under $10M in rev and ~30 employees) uses the temp agency as a long-term screening tool.  Basically, we have found that people are generally good at getting through an interview and a month or two of employment while “holding it together” but people tend to be who they are by say 90 days of being part of the team.
 When you hire someone as a regular full-time employee and then after 90 days or so they start acting out, slacking off, being overly confrontational, etc it is really hard to get rid of them and even if you properly document all the behavior/performance issues they often still end up on unemployment benefits which drives up the premium for the companies unemployment insurance.
 For us, (I can’t say why other companies use temp labor) it is well worth the premium paid to the temp agency to help manage this process.  Especially when considering that bad behavior or animosity towards co-workers can bring about horrible results on a production line, in a busy warehouse, etc…basically anywhere that heavy equipment is running.
 If a temp employee does start acting out, behaving dangerously on the line, etc there is NO paperwork and all we need to do is call the temp agency and say “person X is no longer needed” and that’s it.  The agency may send a replacement for that person the next day if needed.
 However, it is much better value in the long run for the company to hire them, and indeed at my company, those who are eager to learn, want to work as part of the team, be safe, etc are most often offered full employment and benefits with the company in the long term.

I think this fits well with Bryan Caplan's discussion of "employer learning" in his book The Case Against Education, which I wrote about previously. Employers who use temp agencies are in effect laundering the firing process. You're not "fired." You're simply "no longer needed."

I think this is very sad. It means our labor markets are inflexible, and that inflexibility is particularly harmful to low-skilled laborers. I wish the labor market was more fluid. I wish these low-wage laborers could float in and out of jobs more easily. It would be nice if they could work directly for the employers at the normal wage, rather than having to fork over huge sums to the temp agencies. Yes, that might mean some of them get fired more often. However, knowing that they can fire at will, employers would be more willing to actually take a chance on these low-skilled workers. That would be a much more forgiving labor market. It would create opportunities for low-skilled workers, who perhaps have had behavioral issues and a spotty work history.

Why is our labor market so inflexible? It's hard to escape the notion that labor regulations make the problem worse than it needs to be. Mandatory benefits make wages inflexible, because if I have to give you $X worth of benefits, I have to reduce your wages by $X (in an on average and all else equal sense). If I have to pay you a huge severance when I fire  you, it means firing you will be costly, which means I'm less willing to take a chance by hiring you in the first place. There might be good reasons for offering severance packages that have nothing to do with labor regulations. Preserving morale of the existing workers, convincing them the process is fair, etc. But this might make less sense for low-wage workers, who earn their employers pretty slim margins. Common "wisdom" says that labor regulations protect workers from exploitation. I think the shape of the labor market, particularly for low-skilled laborers, implies that there is a huge cost to these regulations. 

Some of the commenters on the Econtalk episode give plausible explanations for the temp agency phenomenon, and some of this is coming from employers who actually make hiring and firing decisions. They are explaining their actual reasons for being inflexible in hiring/firing decisions. If you're usually dismissive of arguments about regulations having counter-productive effects, I implore you to not dismiss so easily. This excellent essay in Regulation Magazine by Warren Meyer seems appropriate to this discussion.

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By the way, Noah Smith makes the absurd argument that big companies can keep wages down because they wield "market power." That would imply that big companies earn enormous returns on their low-wage workers. Given the temp agency phenomenon discussed above, given that low-wage workers are the first to lose their jobs during an economic down-turn, and given that these workers experience the highest rates of unemployment, I find these arguments kind of ridiculous. Maybe I'm being dense, and the high unemployment is actually part of the "monopsony/ market power" story: "Large employers employ fewer people than they would if they were forced to offer the market wage. That's how they keep wages down, by keeping people unemployed. Fewer workers means you're lower on the supply curve for labor, which means you can pay lower wages. D'uh!" But that doesn't make sense to me. Someone who is turned down by Wal-Mart can go work for McDonalds or KFC or Walgreens. At least one of these companies will hire this worker, whom they could supposedly exploit for a huge return on investment. The monopsony story implies more than one big employer wielding market power. It implies that all big employers are conspiring together to keep labor costs down, and they are all resolutely resisting the urge to earn huge profits by "cheating" on the deal. This is a "secret cabal of evil businessmen" level conspiracy theory.

A second aside. Caplan has a long section in his book about "IQ laundering." As in, explicit IQ testing is illegal if it leads to racial bias (which it often does), so educational credentials launder the IQ test. Universities effectively do the IQ testing for the employer, via years of coursework and student selection. Employers can then merely impose a degree requirement for a job and escape the threat of lawsuits they would incur if they used explicit IQ tests. Caplan does some back-of-the-envelope math to show that the effective penalty for IQ testing is a pittance compared to overall labor costs. If it were beneficial to do so, most employers would gladly flout the law and do IQ testing.

If someone did a similar back-of-the-envelope calculation for "wrongful termination" lawsuits, I'm curious how that would turn out. Maybe employer fear of wrongful termination lawsuits is vastly exaggerated, but they still are averse to firing. But if this were the case it would undercut Caplan's story about IQ laundering, because it would demonstrate that employers sometimes have irrational fear of small costs. Caplan's estimate of the "IQ testing penalty" is based on legal defense costs and settlement amounts, but maybe the threat of bad press about being a racist employer is more salient in the minds of HR professionals than the explicit dollar costs.