Marginal product, & incomes

How do you convert ability into income? This is a question promoted by Ann Bauer's claim that novelists often need subsidies from their family. Her point broadens. Many artists struggle to get by: I suspect Jolie Holland speaks for many when she says she barely makes a living.

A novelist, academic and CEO might have very similar intellect and skill levels, but their income could differ by factors of thousands - and, as Will points out, academics' working conditions are deteriorating. Why the difference?

The conventional neoclassical answer is that wages equal marginal product, and that CEOs have a higher marginal product than others. This is a just-so story which glosses over a lot.

For one thing, what matters is that one's product be monetizable and appropriable. The great writer or musician creates an enormous amount of consumer surplus, but she cannot capture this for herself. Quite the opposite; as Gillian Welch sang*, she is under pressure to give away her work. Similarly, if you believe human capital theory, academics - at least the better ones - create billions of pounds of value. But they don't see much of it. By contrast, the CEO's output is more monetizable.

There are at least five reasons for this.

1. Ideology. Hiring committees' wishful thinking and overconfidence lead them to believe that they can hire a great CEO who can add millions of pounds of value to a business - so they pay a premium for what might turn out to be mediocre performance or worse. Demand, remember, can be an ideological construct.

2. Supply constraints. Thousands of people think they can write or sing. Their entry into the market makes it harder for the more able artists to get themselves heard. By contrast, a manager can only show his ability by having worked with expensive assets. This creates a lack of supply of managerial talent. The upshot, as Marko Tervio has shown, is high wages for modest abilities.

3. Rent-sharing. Joanne Lindley and Steven McIntosh show that workers in the finance industry earn more than others, even controlling for skill. This, they say, is because of rent-sharing. Bankers go home with big money for the same reason zookeepers go home with shit on their boots: if there's a lot of stuff around, some of it will stick to you. This also explains why footballers earn more than they did in the 60s; it's not because they have more ability, but because there's more money in the game. There are fewer rents in academia - hence lower pay.

4. Efficiency wages. Banks' traders and CEOs generally must be bribed in order to not sell off the firms' assets cheaply. Nobody feels the need to bribe academics to stop them teaching badly.   

5. Reciprocity. The mere act of communicating with people leads them to treat us more generously. And conversely, if people are out of sight we are apt to treat them meanly. This gives CEOs an advantage.They are often on personal terms with members of the remuneration committee (if only because they often attend its meetings). By contrast, most of the rest of us have our pay set by people less close to us.

My point here is that Ed Walker is right. Marginal product theory is inadequate at explaining inequality. If you want to understand it, you must look beyond the claim that wages equal marginal productivity. We must ask: what is marginal product measuring, and what isn't it? And: through what mechanisms do wages equal (or not) marginal product?   

* Everything worth knowing can be learned from country music and football.

Comments

[TickyW]

How about worker reps on company remuneration committees?

Not just to set directors' pay but also to set workers'pay.

[Luis Enrique]

"Marginal product theory is inadequate at explaining inequality"

yep. A different question might be what proportion of inequality can be explained by productivity

(and you have to be mentally supple enough to move between how MP works in a theoretical model, and what productivity means in reality. Some of your points are not too far from MP theory, for instance marginal productivity does have something to do with supply, you can think about producing rents, efficiency wages are a modification to MP, not a break from it etc.)

[Carol]

Productivity is usually assumed to be high for those who get highly paid, a fallacy of course, since at best a CEO leverages other people's productivity, at worst a CEO merely prances about talking while others produce. A "meritocratic" star uses other people's work to bolster his/her product. The president of a university certainly isn't productive unless (here in the USA)you count the ability to hornswoggle donors into paying big bucks for the football stadium, which is of dubious value for the university in general. And so on.

[rogerh]

I think this is fairly simple, it has to do with how closely coupled the individual is to the business of making money. A CEO has direct control of the levers so it pays to hire a 'good' one, an academic has little effect - probably no more than 1 in a 100 produces anything monetisable - but some of the other 99 helped along (I suppose) and a few may inspire the students.

The reason accountants and lawyers get more cash is that it is easier and cheaper to set them to work - a laptop and a chair in Costas is all it takes. An engineer needs a laptop plus a biggish factory to make money and a physicist needs an expensive lab plus a biggish factory. So all to do with the length of the chain between the worker and the cash.

As for artists their task is simple, to roll up their sleeves, spit on their hands and write a symphony or a novel or sing a hit tune that other people want to buy, sad for them that the hit rate is small and the time lags long. Only do it if you must.

[Ben]

Well I was reading down waiting for it and no - nothing.

CEOs get paid more because work is a pyramid structure and each layer of management steals from the value added by the workers below them. Carol has this spot on.

Pt 4. Bank workers get paid more to keep them there because the banking industry produces little of value and therefore requires little capital other than intellectual capital (and a crony banking license). A worker can walk out the door with all their knowledge of some arcane system and that's it. This is not possible in a company producing real items of value as physical capital is typically required.

[Kevin Carson]

Clark's idea of "marginal product" is inherently circular. It's whatever a particular input adds to the final price of a good or service.So virtually anything enclosed by a rentier adds as much to final price as the rentier is able to gouge for it.

This is especially true to corporations in oligopoly markets with administered pricing via price leader system, where senior management are the de facto residual claimants and set their own salaries through collusion with their own hand-picked internal directors and compensation committees.

[greg]

Hm. No mention of monopoly. With increasing monopoly power, and thus increasing rent, wouldn't we expect those at the helm of monopoly to receive increasing and extra-normal wages? And conversely, those at the bottom, in the rest of the economy from which the rent is being extracted, there would be less available for wages, and their wages would be suppressed.

It seems to me marginal product theory requires at least a perfectly competitive environment, not only within, but across sectors, and that no longer pertains.

[WVO House]

What?

Top notch artists, singers, and novelists make millions of dollars. Some of them make more than CEOs.

That is the appropriate comparison- the best artists compared to CEOs because by definition CEOs are among the best in their field.

What you seem to be doing is comparing CEOs- who by definition are already established as some of the very best people in their fields- to all artists, singers, and novelists, including unsuccessful ones, or in other words to the average artist.

Don't you see how ridiculous that is?

It's like comparing the 99th percentile of a distribution to the 50th percentile of another distribution and then wondering why the first number is higher than the other...

Because when unsuccessful artists complain that they aren't making money it's probably because they are unsuccessful artists in the bottom percentiles of the artist income distribution, not because artists are somehow systematically underpaid.

Why don't you compare those people to unsuccessful accountants and unsuccessful marketing majors? They are also barely making a living working in Starbucks after college.

Later on you bring bankers and other more "average" business workers into the comparison.

The reason the average banker makes more than the average artist is because the demand for banking services is stronger and more consistent than the demand for paintings of pretty landscapes.

The reason is simple- banking services satisfy very essential and time-sensitive needs for businesses. Pretty landscapes and novels don't.

And obviously marginal product theory isn't enough to explain the labor markets.

Economists know that.

There are many theories outside of simple marginal product that have been developed over the last 30 years.

See Edward Lazaer, Carl Shapiro, and SC Ahn among others.

I don't know why people like you always assume you have found some new flaw in economic theory when economists have known about it and worked on patching it for decades...

[Ralph Musgrave]

As unemployment falls, the unemployed become progressively less suited to vacancies, which means that as unemployment falls, the marginal product of labour falls. And it falls till it hits the minimum wage / union wage or similar. That point is NAIRU.

Ergo unemployment (or more accurately NAIRU) could be substantially reduced if those who temporarily couldn’t find suitable work were subsidised into less suitable jobs.

[chris]

@ WVO House - you're showing Kevin's point that MP theory is circular. Yes, the best-selling artists earn big money. But to call them "top notch" or "the best" is to equate monetizability of (perhaps scant) ability with actual ability. You might as well say that lottery winners are "top notch" at picking random numbers.
Likewise your claim that "by definition CEOs are among the best in their field" is dubious. A CEO is good at becoming CEO. But to assume he's the best is to assume that the process of picking CEOs is perfect. I doubt that.
I'll concede that demand for bankers is high. But this is due in part to the state subsidies the sector gets, and to the lack of supply of proven talent caused by the sort of barriers to entry identified by Tervio.

[Dinero]

If you compare a employer and employee with a businessman working with a business partner there is a different way of looking at it.
If an employer employs one employee and splits the proceeds of that joint endeavor with his employee 50/50 that is equitable. If he has two separate employees and does the same he then earns twice that of one employee, and so on. With the result that as he engages more employees splitting the proceeds of each engagement 50/50 each time, he earns many times that of one individual employee.
A different way of looking at it, maybe useful.

[Jamie]

I agree with WVO. You are making the wrong comparisons here.

There are several million businesses in the UK. Many of them struggle and rely on loans from relatives to get started. A few become mega successes. Equally, there are a large number of musicians in the UK. Many of them struggle and rely on loans from relatives to get started. A few become mega successes. The appropriate comparisons would be a struggling business with a struggling musician. Equally, you might compare the CEO of a large business with a successful musician such as Paul McCartney.

Mega successes in any field combine skills, hard work and a large slice of luck. The CEO of Shell is almost certainly lucky to have been in the right places at the right times throughout his career but the same is true of Paul McCartney. What about football? You point out that a business manager “can only show his ability by having worked with expensive assets” and that “this creates a lack of supply of managerial talent”. I agree but that is also true of Arsene Wenger whom you see as a “great economist”. Talk about double standards!

The generic question here is how should we view luck? Rightists and their stooges in mainstream academic economics try to pretend that good luck is evidence of underlying merit. Meanwhile, leftists seem to want to set up a Ministry of Luck so that they can decree which types of luck should be approved and which should be abolished. Both of these views seem to me to be absurd. Luck is just a fact of life. We can no more abolish luck than we can abolish the seasons of the year.

A more useful discussion would focus on productivity. Productivity is a central aspect of any business, government organisation or macro-economy. As a non-economist who has been reading economic articles and blogs for several years, I find discussions of productivity by economists to be very poor. The important questions are practical in nature and the generic economic theory is mostly irrelevant. What are the main causes of poor productivity in the UK in 2015? Are these causes specific to certain sectors, age groups or geographies? What could be done to improve this situation? Who needs to take what specific actions to make the improvements happen? For example, how can we make oil exploration and production more productive when the price of oil is falling and we need to extract oil from ever more remote locations in the North Sea?

[Luis Enrique]

I think the circularity point is misplaced. Of course productivity refers to output that can be monetized.

I reckon we need to think about the problem in two steps. First, given how things are, who is productive (in the producing revenues sense). Second, why are things the way they are (market power and so forth)? When we ask what explains inequality, we are really considering the combination of these two things. So for example footballers are highly skilled (one) but are only able to make some much money because of market structure (two).

there seems to be a lot of confusion about how a CEO can be productive. Imagine a simple firm in which workers produce things, and every now and then a decision needs to be taken, which requires a CEO. These decisions affect the productivity of the firm, so it is obviously worth paying for better decisions. Here is CEO is productive because her decisions affect firm productivity. So on basis one you can justify their high pay. However we might ask why production needs to be organized in this hierarchical way, and ask whether alternative structures might be more or equally productive without relying on CEOs.

In some circumstances it is better to think about marginal productivity of variations in quality rather than in terms of adding a unit of production. We could think of team production which output is zero unless all team members are producing and adding extra members has no impact on output, so marginal product is not defined. But the quality of team members affects output that varies across team member. An example off top of my head, suppose a legal firm requires one cleaner, one clerk and one lawyer. Now think how much productivity responds to having a more able cleaner, clerk or lawyer. In this way you can think about marginal productivity explaining income.

[Alex Godofsky]

How can you write the above post, and then conclude that marginal product theory is failing to explain this phenomenon? I mean, just reread #2:

Supply constraints. Thousands of people think they can write or sing. Their entry into the market makes it harder for the more able artists to get themselves heard. By contrast, a manager can only show his ability by having worked with expensive assets. This creates a lack of supply of managerial talent. The upshot, as Marko Tervio has shown, is high wages for modest abilities.

Supply constraints push up the marginal product! That is the entire mechanism by which they increase prices.

Contra your assertion, the marginal writer produces zero value because absolutely no one wants to read the shittiest novel written.

[reason]

Chris,
can you show me how you measure marginal productivity (either ex-ante or ex-post)? I don't think it is normally possible.

Further,
as I understand it CEOs seem to be paid a lot as insurance against them making a mess, rather than to encourage to them do good. (Somebody appointing a CEO for an already big company - as against someone being a CEO - is bound to be extremely risk adverse since the downside risk is bigger than the upside possibilities.) Where is risk in this discussion?

[reason]

Chris,
am I correct in understanding it that Mark Terviö has formalized the Peter Principle. Did he give credit?

[WVO House]

Chris, in your last paragraph you start by talking about the DEMAND for bankers and ended up talking about two things that are entirely supply-related: subsidies for banking and the supply of qualified labor in banking...

What does the supply of qualified bankers have to do with the demand for banking services? Demand doesn't go up when supply goes down. What point are you trying to make?

Also, what is this "actual ability" you keep talking about?

To you maybe artistic ability is the ability to move your fingers up and down guitar strings quickly.

But why on Earth should that be the end-all definition of artistic ability?

Being a good artist is also about being able to make things people like, to produce it the right way, to distribute it the right way, to create the right atmosphere around it.

For example, you may not think Katy Perry has the vocal range of some local pub performer but what gives you the right to say that Katy Perry's ability to make and distribute music to the masses is any less of an artistic ability than the local pub performer's singing talents?

Katy Perry's monetary success is a direct result of her portfolio of talents, which include many things from the ability to make noises with her mouth to her ability to appeal to people with her looks to her ability to create publicity.

What you basically want to do is somehow exclude some of those talents from the category "artistic ability" and then attribute her success to the talents you chose to exclude.

That will allow you to claim that some successful artists are not necessarily the most artistically talented if measured on the basis of the talents that YOU choose to define as "artistic".

Why?

What logical and theoretical basis is there for that?

[WVO House]

Reason, if you want to know how wages are actually set and determined- including the ways the factors you pointed out affect wages- read all the work done on the subject by people like Ed Lazaer, Lawrence Katz, Joe Stiglitz, David Card, George Akerlof, Carl Shapiro, Rajesh Aggarwal, Stacey Kole, Canice Prendergast, Kevin Murphy, Xavier Gabaix, and many others.

Even though this blog's author wants to make it seem that somehow this is a huge unanswered question that these silly economists haven't even begun to broach yet, the truth is that economists have spent literally decades developing supplements and alternatives to marginal product theory.

The author is just not familiar with that work and therefore assumes it doesn't exist.

In reality the big issue in this blog has been addressed over and over again through the years.

[drunkard in italy]

Rock and roll banks who don't give a cook and hip hop systems that believe in pimps y h0's have done very well in being more no high earning tax evaders (stones) or even business owners (p diddy)

[reason]

WVO
What nonsense - (not that this sort of work has not been done) - such complications have not been integrated with a basic macro-economic understanding that is generally used in public discussion. And Chris Dillow is perfectly aware of this work.

[Luis Enrique]

reason,

who are you talking about? I claim that when economists participate in general public discussion about income they tend to have more to say than wage=marginal product. Greg Mankiw is exception not rule. The Economist magazine exemplifies the filtering of mainstream economics into public debate, here they are ripping into Mankiw on this topic:
http://www.economist.com/blogs/democracyinamerica/2013/06/inequality

my impression was that 90% of economists thought Mankiw made an utter fool of himself with that article.

if you look at this poll of economics greats, they are not simply saying ability explains income, but that the ground has shifted to favour certain skills, and they all concentrate on supply (like Chris above):
http://www.igmchicago.org/igm-economic-experts-panel/poll-results?SurveyID=SV_0IAlhdDH2FoRDrm

can you find examples of general public discussion where economists simply say income = marginal product, and don't talk about supply, rents, market power etc. too?