Inequality and Pay: “Rents” vs. Merit

April 28th, 2014 at 1:24 pm

In the age of Piketty, it is increasingly recognized that historically high levels of economic inequality are a serious and growing problem in many economies across the globe.  The problems caused by this phenomenon range from stagnant incomes and sticky poverty rates for the majority on the “have-not” side of the divide, to skewed political power (especially, given all the money in politics, here in the US), to possibly slower macroeconomic growth, self-reinforcing wealth accumulation, and a tendency toward terribly damaging bubbles.

The causes of increased inequality are generally viewed to be increased competition through globalization, technological change, diminished union power, lower minimum wages, and persistent slack in the job market, which has the effect of significantly lowering the bargaining power of most workers.

But there’s another alleged cause: there’s a lot more inequality, especially in earnings, because in this day and age, really talented people are finally able to get paid what they’re actually worth (and note that it is rising high-end earnings that explain most of the growth in inequality in recent decades).  Some of the factors listed above play a role here, as technology and trade have created access to broad new markets where millions more consumers can interact with producers of entertainment, apps, and clever financial instruments.  These forces have helped to unleash the earning power of a small number of individuals who are simply and legitimately earning their “marginal product,” i.e., the true value of their contribution to the world (hereafter MP).

Now, I happen to think that’s wrong, but contrary to popular opinion, it’s actually the first assumption made by economics in evaluating pay.  The average person looks at figures showing more wealth or income inequality than ever and sees something out of whack.  In economic terms, they see evidence of “rents:” people who are, by dint of some economic inefficiency, being paid well beyond their MP.  But the economics textbook sees, by assumption, fair remuneration.

It’s both interesting and important to think about why that’s wrong.  Moreover, it not a simple case to make.  For one, an individual’s contribution to her firm’s bottom line (MP) is awfully hard to back out.  Sure, if your factory of 10 workers makes 100 widgets, and, with no changes in technology or prices, you hire one more person and end up with another 10 widgets, you can easily derive the marginal gain.  Of course, the real world is more complex.

For example, suppose you could observe relevant market changes wholly outside the control of a CEO and gauge their impact on her compensation.  That would make a nice test of the MP theory, since CEO pay shouldn’t fluctuate due to such external factors.  A clever paper by Betrand and Mullainathan examines just that possibility, through a case study of executive salaries in the oil industry, where the product price is clearly set on the global market.  Yet, in contrast to MP assumptions, they find not only that CEO pay in the industry increases with positive price shocks—“oil CEOs are paid for luck that comes from oil price movements”—but that the increase tends to be asymmetrical: these execs are paid more for good luck than they lose for bad luck.

Next, there’s what I think of as the discontinuity hypothesis, a particularly strong, though nuanced, bit of evidence against the conventional MP theory.  The idea here is that if the very talented are finally getting their just desserts, this should occur along a fairly smooth continuum.  That is, there’s no plausible meritocratic reason why those at the 98th percentile of the skill distribution should be doing just OK while those at the top 0.1 percent are raking in the stuff.

Yet the figure below, from research by Josh Bivens and Larry Mishel, reveals precisely such a discontinuity (their paper is one of the most important in recent years on this question of rents).  Each line shows the ratio of CEO compensation to the top 0.1 percent of both household incomes and wages.  For decades, the lines wiggled around their historical average, before shooting up sharply in the era of heightened inequality.

rents1

Source: Bivens and Mishel, 2013.

While an MP advocate might want to bend herself into a pretzel to describe a model wherein the productivity of the top CEOs pretty suddenly far surpasses that of not the average worker, but the 99.9th percentile worker, such contortions begin to seem implausible, if not desperate.  In fact, one problem with the MP assumption is that there is no distributional outcome with which it is inconsistent.

This next example of rent-seeking is the one I find most interesting and perhaps most germane to the nature of inequality today: underpriced risk in finance. 

Suppose your company designs cars and a sharp new engineer comes to you with this offer: I can build you a fast, sexy car that gets awesome mileage and is easily affordable to your customer base.  Let’s say you believe her and offer her a fat pay package of X.  Now imagine a similar rap with one twist.  Your genius engineer offers you the same car, but adds the fact that it tends to crash a lot.  You still might offer her a job, working on risk-reduction.  But you’d do so for a fraction of X.

The finance sector, unsurprisingly, has been the focus of some of the most interesting research on rents and a few themes have surfaced, including that of underpriced risk, negative externalities, and the role of deregulation.

First, when someone asks me to explain the Great Recession in two words—it’s happened more than once—I say “underpriced risk” (or maybe “housing bubble” but they’re intimately related).  The point in this context is that for years now, finance has supported outsized compensation packages that quite inefficiently fail to reflect the damage that the camouflaged risk of their products pose to the rest of the economy.  It’s a classic externality problem: the costs imposed by the actions of these financial “innovators” have clearly not been netted out of their compensation.

It’s even worse.  Not only have they been overpaid relative to the damage their sector has caused, but many of them and their institutions have been made whole at the taxpayers’ expense once the depressed risk pricing was revealed and the bubble burst.

Aren’t the financial regulators supposed to prevent this?  Of course, but the fact that they’ve been outgunned by lobbyists and in many cases, seemingly captured by the finance industry, has them playing catch-up at best, and this too is major contributor to rents.  Take a look at the figure below, from a paper by Philippon and Reshef that plots an index of financial deregulation against relative pay in the industry (an increase in the deregulation index implies looser regulation).

rents2

Source: Philippon, Reshef (2009).

The fit between deregulation and pay in finance relative to the economy-wide average is tight, but does this really disprove MP theory?  Perhaps it just shows that when you un-cuff Adam Smith’s invisible hand, it works efficient wonders that plodding regulators were formerly blocking.  Yet, along with the pretty dispositive negative externality point above, there’s a growing body of work relating the growth in the finance sector to price distortions (overpriced financial intermediation), unproductive rent-seeking, and of course, systemic risk.

I could go on in far greater detail, but I’ll spare you, other than to note that other advanced economies facing the same technological and global forces as us fail to pay their executives so exorbitantly.  One area where this is particularly clear—where “rents” seem excruciatingly obvious—is in health care, where pharmaceutical and physician lobbies continue to extract hugely higher costs than are seen elsewhere for similar goods and services.

Finally, what about the superstars?  As economist Greg Mankiw argues, it’s not at all obvious that Robert Downey, Jr. didn’t deserve $50 million for playing Iron Man in a recent film.  Again, Mankiw’s arguing by assumption—the actor must deserve $50 mil because he got $50 mil—but it’s harder to see the market failure here than on Wall St.

Here though, I’d evoke Bivens and Mishel’s notion of rents or as they call it, “inefficiently high pay:” paying someone more than you need to in order to get them to do the job.  I too am in the realm of assertion here, but I’ll bet Downey would have done the job for $45 million, though research on “positional pay” suggests he’d only go there if his nearest competitor took a similar pay cut (if I’m wrong about all this, Bob, have your people call my people).  Heck, I’d take the part for a couple hundred K—could I really be $49.8 million worse than Downey?

OK, now I’m arguing by assumption so let’s stop.  But to look at the inequality landscape and sweepingly assume, with Panglossian certainty, that this is the best and most just of all possible income distributions looks to me to be in pretty deep denial of the evidence and the historical record.  And the policy implications of this evidence are actually profound: once you accept that our economy is functioning ever less as a meritocracy, you pave the way—at least you should pave the way—for a lot of corrective public policy, starting with more progressive taxation on high earnings and wealth.

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24 comments in reply to "Inequality and Pay: “Rents” vs. Merit"

  1. Sandwichman says:

    “As economist Greg Mankiw argues, it’s not at all obvious that Robert Downey, Jr. didn’t deserve $50 million for playing Iron Man in a recent film.”

    And as economist Thomas Piketty argues, the “superstars” only account for 5% of the top 0.1 percent (1/1000) of the income hierarchy. Sixty to seventy percent are corporate management (p. 302-3). Why then does Mankiw insist on using the atypical case as illustrative? Because the data don’t support his argument.


  2. smith says:

    The movie industry is notoriously monopolistic. While the studio system no longer exists, there is an arms race of movie promotion among distribution channels that crowd out competitors keeping the cost of entry prohibitively high. Even behemoths such as HBO and Netflix enter the arena cautiously. There was the case of United Artists where artists united to form their own studio in the 1930s, and the anti trust case in the 1940s to break up the vertical integration whereby studios had to sell off their interest in theater chains. Today tens of millions of dollars are spent on productions that are no better than movies made for a fraction of the cost (adjusting for inflation) http://en.wikipedia.org/wiki/List_of_most_expensive_films So too, sports stars are subject to the same non-competitive pressures where the business model is closed, monopoly is enshrined in law, and athletes would be foolish not to gain as large a share as they can of the rents extracted from the 99%. Using very uncompetitive industries as a model for compensation is ridiculous. A dozen coffee shops opened up in my neighborhood recently to compete with Starbucks, but not one movie studio, bank, or brokerage firm. Guess who gets paid more?


  3. smith says:

    http://topincomes.g-mond.parisschoolofeconomics.eu/#Database:
    http://cbo.gov/sites/default/files/cbofiles/attachments/44604-AverageTaxRates.pdf
    Why does the CBO estimate the 1%’s share of income before taxes including capital gains as 14.9%
    vs
    Piketty’s database showing the same group’s share a much higher 19.86%

    This is for the year 2010, so roughly 15% vs 20%, a difference of 5% of national income (before taxes), a huge, huge difference in a very important measure of inequality. I’m inclined to believe Piketty since one assumes his expertise in the area is greater than the CBO, but someone should point examine this and have the CBO make corrections if warranted (at least for future work). Up until the publicity surrounding the book, more people looked at CBO reports than the Paris School of Economics website.


    • smith says:

      A critique I read of Piketty complained his income figures leave out government benefits including social security, and employer benefits like health care contributions. So maybe that’s where all or some of the difference with the CBO report comes from. 5% is $600 to $700 billion, which would be . $2,000/per person. That’s $8,000 for a family of four. That’s a lot even for median of $50,000. But median income is a bogus figure because most of those making less than $50,000 make a lot less. The bottom half is concentrated at the bottom. 1/3 make less than $30,000, averaging less than $20,000. So $8,000 is a big deal and sure enough when you look at countries with less inequality it’s because the lower bottom gets more and the upper top half get less. It’s not because the middle class do better.

      Also, it makes sense not to add food stamps to income in measuring inequality. Still, the differences in measurement should be debated. Currently the CBO has a totally different way which diminishes the difference in rewards segments of our society receive for work.


  4. Bearpaw says:

    The idea that everyone is paid exactly — or even approximately — what they’re worth has become a matter of ego-based faith, especially among people who “earn” the equivalent of millions or billions of dollars. And particularly among the subset of that group who “earn” that much by inventing new ways to rip people off.


    • jonas says:

      As someone who agrees with you, I would point out that “wage = value of the marginal product” is a good place from which to start an analysis. The lazy-man’s mistake is in thinking it’s a good place to end.


  5. Sandwichman says:

    Am I the only one to notice that Piketty titled one section of his book “The Illusion of Marginal Productivity”? He’s pretty unequivocal about the limitations and naivety of the marginal productivity theory, along with Cobb-Douglas production function, Kuznets curve, representative agent modeling and the Gini coefficient, just to name a few canards.

    For all the talk about Piketty’s book, I Googled “the illusion of marginal productivity” and came up with no other hits than T.P.’s book itself. Piketty is not just saying that inequality is huge; he is saying quite pointedly that conventional mainstream economics is incompetent and the proof of that incompetence lies in its abject failure to comprehend the inequality story.


  6. Fred Donaldson says:

    The civil rights movement, which really began in the late 18th century, never fulfilled all its dreams until the establishment noticed with alarm that something was wrong and needed immediate action to change inequities. The recent OWS movement to more regulate banks, began in such a vein, but sadly lost focus and was demonized for lack of direction and confusing multiple social and economic goals.

    While economists argue, some honestly and some not, the middle and lower classes in America need a spark to not just boost the GDP, but to improve lives of two generations affected by reduced wages and prices often controlled by fewer competitors in the marketplace and more association-based price agreements within industries.

    My suggestion is to buy a billboard. March on the streets. Brandish farm instruments, such as pitchforks, roofing material, such as tar, and feathers, in case of a pillow battle. The billboard would read:.

    “15 and 40 or FIGHT”

    That stands for a fair minimum wage of $15 an hour and 40 hours pay, not part time or poverty wage labor that only benefits shareholders and CEOs, while impoverishing workers, builders and innovators on the job site..


  7. Perplexed says:

    Wow, lots of “stuff” packed into this post! But the “stuff” left out is at least as interesting.

    -”The average person looks at figures showing more wealth or income inequality than ever and sees something out of whack. In economic terms, they see evidence of “rents:” people who are, by dint of some economic inefficiency, being paid well beyond their MP. But the economics textbook sees, by assumption, fair remuneration.”

    Its not just “the average person” that sees “something out of whack.” Anyone with a background in mathematics, logic and reasoning, engineering, or most physical sciences will quickly be able to see that there is a serious “logical” problem with the explanation that the “marginal contribution” of one person at the top of a huge organization is several hundred times that of others in the organization. Economists should understand that the rest of us are “looking at the tops of the mast disappearing last as the ship sails away” and are very much wondering why economic “scientists” are pounding their collective fists and swearing that they’re certain that the earth is flat. The question at this point is why do economists, as a group, cling so dearly to these claims instead of focusing the necessary resources on finding out what is really going on? Is it incentive based? Is it driven by fear? Fear of what specifically? If these “salaries” are marginal products, why is that economists can’t point to the the specific skills and actions that are performed by these people that “produce” these “products.” Why are economists not troubled by the fact that clairvoyance would be the only “skill” rare enough that it might come close to having this kind of “market value”?

    -”First, when someone asks me to explain the Great Recession in two words—it’s happened more than once—I say “underpriced risk” (or maybe “housing bubble” but they’re intimately related).”

    Yes, and they’re intimately related to an even more precise two word explanation: counterfeit fraud. If banks had used printing presses to print trillions of $’s of fake treasury bills and sold them to investors as real ones, the results would have been similar (with the exception that homeowners would not have been specifically targeted as victims.)

    -”The causes of increased inequality are generally viewed to be increased competition through globalization, technological change, diminished union power, lower minimum wages, and persistent slack in the job market, which has the effect of significantly lowering the bargaining power of most workers.”

    So why is that monopoly and monopsony power fail to make this list? How do you tell a story about rents without including what is likely to be by far the largest generators of rents: lack of competition, monopolies and other barriers to entry, lack of transparency? Why is that so many years after Keynes we know so little about the total rents in the economy and their sources and distribution? Was the net effect of our investment in the “science” of economics over the last century to make us understand the real workings of the economy less than Teddy Roosevelt did? Are economists really just producing obfusction and providing cover? What is becoming increasing clear as we delve into the inequality debate is that our understanding of how income is actually distributed in an economy is “primitive” at best. By adopting the “marginal products” theology, the “science” of economics has avoided addressing almost all of the most important questions surrounding the actual distributions of rents and the role of power in that distribution. It appears that this is by design, a feature, not a bug. Why are exceptions like Piketty so rare in economics.? Why wasn’t the “science” screaming for more transparency about the distribution and magnitudes of rents in the economy? If you had plutocrats design a “science” to promote their interests could they come with something better than the “science” of economics in its present form? One that doesn’t even bother to attempt to measure rents and “assumes them away” in marginal products theology. Fortunately there economists like Piketty, Saez, Zucman, Acemoglu, Stiglitz and others that are piercing the protective shield of marginal products to reveal what its concealing. Another who has been focusing quite specifically on rents on how those in power manage there distribution to others in power while at the same time denying access to them by others is Jose Gabriel Palma. He has quite a different list of what is behind the inequality: http://www.dspace.cam.ac.uk/bitstream/1810/241870/1/cwpe1111.pdf. His explanation seems a whole lot more compelling than “marginal products.”

    -”But to look at the inequality landscape and sweepingly assume, with Panglossian certainty, that this is the best and most just of all possible income distributions looks to me to be in pretty deep denial of the evidence and the historical record.”

    So what will it take to get the “science” of economics to refocus its efforts into finding out how the real world works instead of “digging in their collective heels” to protect marginal products theology? What’s the rents/GDP ratio again? Not important right? Just ask almost any economist.


    • smith says:

      I am perplexed too.

      As Perplexed quotes the blog post:
      -”The causes of increased inequality are generally viewed to be increased competition through globalization, technological change, diminished union power, lower minimum wages, and persistent slack in the job market, which has the effect of significantly lowering the bargaining power of most workers.”

      And then responds:
      So why is that monopoly and monopsony power fail to make this list? How do you tell a story about rents without including what is likely to be by far the largest generators of rents: lack of competition, monopolies and other barriers to entry, lack of transparency?

      I would add for reference my previous post quickly dismisses the notion even movie stars deserve outsized rewards, instead attributing their compensation to a monopolistic industry. It closes pointing to the pernicious effect of monopolies or oligopolies dominating finance.

      But I’m asking myself now, how I didn’t also directly question the list of causes, and I think it’s because Piketty focuses on capital and commentary on Piketty rarely mentions labor issues. So it’s a relief to see them prominently discussed in this blog. However, if you’re listing causes (not effects) of inequality, how can you leave market domination of large firms off the list? And what about tax policy? The Eisenhower rates of 90% on $2 million dollars (that is the inflation adjusted figure) doesn’t just redress process that creates inequality, it acts as a deterrent, a disincentive which conservatives all too readily admit. They don’t understand, that’s the point. Evidently neither do many liberals. What’s more, how can you ignore the role capital plays in instigating and propagating inequality.

      All of the causes and changes listed, globalization, technological change, diminished union power, lower minimum wages, and persistent slack in the job market, are created and fostered directly through legislation, government action, which opens up our markets without reciprocal trade, rewards currency manipulation, accelerated depreciation of machinery replacing workers, non-functioning NLRB for four years, erosion of wage floors, expansion of unpaid work hours, government deregulation that leads to speculative busts and slack job markets, strong government action for banks, but not labor and home owners. One could even cynically argue the large in absolute terms, but too small relative to the recession stimulus was essential to restore corporate profits, and uncoincidently just to their maximum.

      Saying inequality leads to more inequality is inaccurate. People with some money launch a campaign to gain an advantage which creates greater inequality, starting with very important changes to tax law and regulation in the Reagan era, before rising inequality becomes a huge problem. As it snowballs, don’t confuse cause and effect. Capital causes the labor power erosion, starting with Taft Hartley. It’s not the other way around, labor losing power mysteriously or to inevitable changes in the world economy like increased trade, technology, unexplainable unemployment from jobless recoveries.
      Finally, where is greed and the failure of democracy to ensure a just society? Even without the current level of inequality, rich people run things, they control “the means of production”, have an outsized influence on government policy. Owners tend to pay themselves very well and not so much, their workers, big surprise.
      A main point of Piketty’s data (which those observing the slow death of the New Deal have known) is the mid 20th century was an exception, and caused by non reproducible circumstances. Focusing on how to restore what we once had and who stands in our way would be a good start.


  8. Michael Gamble says:

    I wonder why since most of these astronomical salaries that some people bring down, why more share holders are not up in arms? Now I know for instance in the Robert Downey Jr. case he might be integral to the films success, debatable but I see the point, still that wage definitely comes out of the profits for the film? When you take that one instance and multiply it by all major corporations in America….. But I do feel it is just an illusion to think that some CEO is worth now what 300% more to his company than the same executive in the 60s?


    • readerOfTeaLeaves says:

      I don’t see that Mankiw linked Downey’s pay to any performance measure whatsoever. There are many factors that go into the success or failure of a film, but Mankiw would be on stronger ground if Downey’s contract stipulated that he’d be paid the full $50m if, and only if, the movie made 400% of its production costs. If it only made 200%, he’d get $25 m. Et cetera.

      Meanwhile, the fit between deregulation and exorbitant finance income is more than a little interesting. Particularly when it is overlaid with these graphs, particularly #1 (increasing inequality in recent decades), #4 (tax cuts for the wealthiest), #6 (impact of Bush II policies on deficits), #7 (where the deficits actually originated – tax cuts, unpaid for wars, and deregulated finance that damaged the economy), #12 (dropping real income in middle class households for a generation):
      http://jaredbernsteinblog.com/the-best-of-cbpp-graphics/

      BTW: I had to do a google search to locate those graphs; there is no ‘Best of Charts’ pulldown in the blog’s ‘search’ categories. Maybe that could be fixed…?


  9. Tom Cantlon says:

    Please point out the flaw in my thinking. The idea that anyone, certainly anyone in the hourly-wage to mid-management range, would be paid according to their value seems obviously wrong. An employee may bring big $ in but if there are plenty of others eager and able to do the job the employer is obviously only going to pay what it takes to get them. Ironically today’s WPost opinion section has a piece about the amazing low pennies pro NFL cheerleaders are paid. I’ll guess their value to the overall TV/Football extravaganza is not small, but there are many women who’d be willing to take the job if an existing cheerleader demanded more pay, so their pay is based strictly on what it takes to replace them, nothing to do with MP. Right?


    • Fred Donaldson says:

      There are swindlers who cheat unwitting victims out of their life’s savings. We call that a crime and regulate commerce to exclude it.

      Swindling the unwitting out of a living wage is no different and yet is praised by some as a victory, like the fox “outsmarting” the hen.


  10. save_the_rustbelt says:

    Pulling professional athletes or entertainers into the discussion distorts the conversation, they are outliers in the world of compensation.

    About the only thing worse than we have now would be a government attempt to regulate compensation.


    • Perplexed says:

      -”Pulling professional athletes or entertainers into the discussion distorts the conversation, they are outliers in the world of compensation.”

      They are indeed a distinct type of monopoly, but until we know the rents/GDP ratio, we really don’t know how much of an “outlier” from an income distribution standpoint. Either way, their combined impact is dwarfed by other monopolies and rents.

      -”About the only thing worse than we have now would be a government attempt to regulate compensation.”

      But, OTOH, possibly one of the best would be tax rates based on whether your income included any form of monopoly profits or rents. Start by assuming they do for incomes over a certain threshold and put the onus on the recipient to show otherwise to qualify for a lower rate. Those who profit by being better competitors shouldn’t be taxed at the same rate as those who profit by avoiding competition. We need the revenue to bolster public goods like education and infrastructure and there’s no more justifiable place to get it than from rentiers. Its time we moved towards a system of rent-free capitalism but we need a “science” that can help measure and expose where the rents are instead of trying to conceal them and avoid the question with marginal products theology. Its scary to think of how much cumulative damage in human terms this religion has inflicted in the last century alone.


  11. Tom Cantlon says:

    Mr Berstein, I really am interested in knowing if I’m off track. It seems that while wage would typically track with MP and difficulty of acquiring a skill, not necessarily. If replacements are cheap and plentiful then that trumps, and wage might be lousy despite high MP. High unemployment causing a general reduction in wages over time confirming that. True?


    • jonas says:

      I think you’re right on. That’s what I was getting at above. Wages are /related/ to the value of the marginal product, so that’s a good working hypothesis. I’m not aware of a good model that incorporates factors like market power; I’d love to see one if it’s out there.

      The problem is that it’s so hard to formalize these factors. We all know how monopoly, monopsony, oligopoly, and similar structures work. Those we can model. We have more trouble if the institutional structure doesn’t fit one of those.


  12. CDB says:

    If we believe in microfundamentals, it can be proved (and should be just generally obvious from basic entropy theory), that income distribution should be log-normal, and it is for about 90+%. This distribution doesn’t forbid high incomes, only predicts their proportion, and it thus accounts for the superstars, such as actors, athletes, inventors, etc. (See the Journal of Entropy for a formal proof of this.)

    However, there is a Pareto distribution at the high end and this should arouse our suspicion that something is rotten in Denmark. There are a lot of possibilities, but something has to be wrong.


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