It’s fitting that Mervyn King should have been a director at Aston Villa – because that job, like his previous one, has given him a close-up view of the failure of mainstream economics.
I’m referring to the idea that wages equal marginal product. Aston Villa’s wage bill this season was higher than Leicester’s. This difference is not reflected in their marginal product. In fact, Villa owner Randy Lerner is sitting on a loss of over £200m.
This highlights an under-appreciated distinction: people are often not paid their actual marginal product, but their expected marginal product. Villa paid Joleon Lescott and a ragbag of Carlos Kickaballs £50,000 a week because they expected them to save the club from relegation. Such expectations proved over-optimistic.
This is not an idiosyncratic example. Across whole professions, wages can be inflated because expected marginal product exceeds actual marginal product. Fund managers, for example, are paid millions for mediocre performance because gullible investors over-estimate their ability to beat the market. I suspect the same is true of corporate CEOs: managerialist ideology causes remuneration committees to over-estimate the extent to which an heroic leader can improve the company, and so pay too much. If bosses were paid their actual marginal product, Fred Goodwin and Dick Fuld would have had salaries of minus billions of pounds. They didn’t.
I’d add that there are at least three other reasons why pay can deviate from marginal product, especially at the top end.
First, value is often determined not merely by individual’s production, but by team production, which makes it difficult to identify an individual’s marginal product. As Lars Syll says (pdf):
It is impossible to separate out what is the marginal contribution of any factor of production. The hypothetical ceteris paribus addition of only one factor in a production process is often heard of in textbooks, but never seen in reality.
For example, the same manager, for example, might or might not add value depending (pdf) upon whether his skills are a good match or not with the organizations.
This can cause pay to exceed marginal product because the fundamental attribution error leads hirers to over-estimate individuals’ contributions and under-estimate organizational factors – as happened, for example, when ITV hired Adrian Chiles and Christine Bleakley on big money in the mistaken hope that they would attract viewers.
Secondly. wages can exceed marginal product in efficiency wage situations, where workers must be bribed not to steal the firms’ assets. This explains why bankers are paid so much. I suspect the same applies to CEOs.
Thirdly, power matters. Dani Rodrik has shown that even controlling for productivity workers are better paid in democracies (pdf) because these are associated with stronger workers’ bargaining power. In the same spirit, economists at the IMF show that CEOs pay is lower when trades unions are stronger.
All of this is to vindicate a point made by Joe Stiglitz – that evidence for the validity of marginal product theory, especially at the top end, “remains thin”.
Now, you might object that some of the examples I’ve given are of disequilibrium: Fred Goodwin’s job didn’t last long, and Villa players’ prospects aren’t great. But all theories are true if you ignore the exceptions. Life is lived in disequilibrium, and a few years of egregious deviations from marginal product can generate big inequalities.
It could be that marginal product theory – just like simple-minded talk of incentives – is as much ideology as science.
here is one way of thinking about why MP is the wrong way to think about CEO.
suppose output is produced by n workers, who together perform a 'task'. Marginal productivity is well defined, for a given task, so you can add and subtract workers and output goes up and down like so: Y=t*(sum W_n) where W is the ability of worker indexed n
t is the chosen task, and in addition to the workers, there is a CEO who selects a task. For shareholders in such a business[1], choosing a CEO who is capable of finding a high value t would be worth paying a lot. But the CEO pay has to come out of output, so the more they are paid, the less there is left for the workers. If you pay the CEO anything at all, they get less than MP. But from point of view of workers, it is also worth finding a CEO who can deliver a high value t, because that's how they can get higher wages too. So CEO and workers have to bargain over wages.
The point of this toy model is simply to demonstrate how easy it is to get to a point where W=MP makes no sense. As I pointed out in my first comment, this sort of thing has been commonplace in mainstream econ for decades.
[1] I realise I haven't added capital to production
Posted by: Luis Enrique | April 21, 2016 at 10:39 AM
here is Gabaix - an extremely high status economist within the mainstream - with a survey on CEO pay
http://pages.stern.nyu.edu/~xgabaix/
"... traditional optimal contracting theories find it difficult to explain the data, suggesting that compensation results from "rent extraction" by CEOs."
Posted by: Luis Enrique | April 21, 2016 at 10:44 AM
sorry, Gabaix's webpage does something funny with urls, here is better link
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2576707
Posted by: Luis Enrique | April 21, 2016 at 10:47 AM
sorry for all the comments, but I'd further like to add that imo it is perfectly valid to argue that choosing a organizational form of the type sketched in my toy model is tantamount to conferring wealth on those lucky enough to be considered in the pool of CEOs, and that alternative models such as, for example, having the task chosen democratically by workers, would be better. I do not know what most mainstream economists would say about this, but imo it's definitely valid not just to ask what determines incomes with a certain system of economic organization, but to attribute incomes distributions to the nature of that system and think about alternatives.
Posted by: Luis Enrique | April 21, 2016 at 11:21 AM
The solemn burial of marginalism
In order to tackle the problem of wages and employment economics has to switch from microfoundations to macrofoundations. The paradigm shift is achieved as follows.
(A0) The objectively given and most elementary configuration of the (world-) economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm.
(A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L,
(A2) O=RL output O is equal to productivity R times working hours L,
(A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.
These premises are certain, true, and primary, and therefore satisfy ALL methodological requirements. The macro axiom set contains NO NONENTITIES like utility, maximization, equilibrium, or a well-behaved production function. For the graphical representation of the absolute formal minimum set see link #1.
At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the conditions of (i) budget balancing, i.e. C=Yw and (ii) market clearing, i.e. X=O. Note that the ray in the southeastern quadrant is NOT a linear production function; the ray tracks ANY underlying production function. Note also that the wage rate W is an AVERAGE if the individual wage rates are different among the employees, which is normally the case. These details are not needed at the beginning but come later with DIFFERENTIATION.
Under the conditions of (i) market clearing and (ii) budget balancing in each period the price is derived as P=W/R (1), i.e. the market clearing price is in the most elementary case equal to unit wage costs. This is the elementary form of the Law of Supply and Demand which, in a later step, has to be generalized for an arbitrary number of markets.
The first thing to notice is that the real wage W/P is invariably equal to the productivity R according to (1). So, for the economy as a WHOLE the marginal principle does NOT hold. The real wage is NOT equal to marginal productivity — because there is NO marginal productivity — because there is NO such thing as a well-behaved production function. The real wage is equal to productivity.
Marginalism must ASSUME a well-behaved production function in order to make the green cheese assumption of constrained optimization work. This is methodologically ILLEGITIMATE and known since antiquity as petitio principii. To fool around with ASSUMED NONENTITIES is like kindergarten kids playing with Spiderman, Tooth Ferry, and Easter Bunny.
For the economy as a WHOLE holds: If the wage rate W is lowered, the market clearing price P falls. If the number of working hours L is increased the price remains constant, provided productivity R does not change. If productivity decreases the price P rises. If productivity increases the price falls. In any case, labor gets the whole product, and profit for the business sector as a whole is invariably zero. So, the next question is where does profit come from? This question has NEVER been answered by standard economics. So economists have NO idea of the most important phenomenon of their subject matter.
All changes in the system are reflected by the market clearing price. The most elementary economy is REPRODUCIBLE for an indefinite number of periods under the interim condition of no external limitations. With further DIFFERENTIATION one eventually arrives at the correct employment equation #2 and eventually at a single firm, that is, at micro.
What is standard economics? Krugman put it thus: “most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point”.
And this is why Krugman and the rest of standard economics is a failure. If the premises are false the whole theoretical superstructure implodes with karmic neccessity. It is as simple as that: garbage in, garbage out. This methodological truism, though, is forever beyond the ant horizon of marginalist losers.
Egmont Kakarot-Handtke
#1 Wikimedia, The pure consumption economy with market clearing and budget balancing https://commons.wikimedia.org/wiki/File:AXEC31.png
#2 Wikimedia, The structural employment equation https://commons.wikimedia.org/wiki/File:AXEC62.png
Posted by: Egmont Kakarot-Handtke | April 21, 2016 at 11:37 AM
The solemn burial of marginalism
In order to tackle the problem of wages and employment economics has to switch from microfoundations to macrofoundations. The paradigm shift is achieved as follows.
(A0) The objectively given and most elementary configuration of the (world-) economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm.
(A1) Yw=WL wage income Yw is equal to wage rate W times working hours. L,
(A2) O=RL output O is equal to productivity R times working hours L,
(A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X.
These premises are certain, true, and primary, and therefore satisfy ALL methodological requirements. The macro axiom set contains NO NONENTITIES like utility, maximization, equilibrium, or a well-behaved production function. For the graphical representation of the absolute formal minimum set see link #1.
At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the conditions of (i) budget balancing, i.e. C=Yw and (ii) market clearing, i.e. X=O. Note that the ray in the southeastern quadrant is NOT a linear production function; the ray tracks ANY underlying production function. Note also that the wage rate W is an AVERAGE if the individual wage rates are different among the employees, which is normally the case. These details are not needed at the beginning but come later with DIFFERENTIATION.
Under the conditions of (i) market clearing and (ii) budget balancing in each period the price is derived as P=W/R (1), i.e. the market clearing price is in the most elementary case equal to unit wage costs. This is the elementary form of the Law of Supply and Demand which, in a later step, has to be generalized for an arbitrary number of markets.
The first thing to notice is that the real wage W/P is invariably equal to the productivity R according to (1). So, for the economy as a WHOLE the marginal principle does NOT hold. The real wage is NOT equal to marginal productivity — because there is NO marginal productivity — because there is NO such thing as a well-behaved production function. The real wage is equal to productivity.
Marginalism must ASSUME a well-behaved production function in order to make the green cheese assumption of constrained optimization work. This is methodologically ILLEGITIMATE and known since antiquity as petitio principii. To fool around with ASSUMED NONENTITIES is like kindergarten kids playing with Spiderman, Tooth Ferry, and Easter Bunny.
For the economy as a WHOLE holds: If the wage rate W is lowered, the market clearing price P falls. If the number of working hours L is increased the price remains constant, provided productivity R does not change. If productivity decreases the price P rises. If productivity increases the price falls. In any case, labor gets the whole product, and profit for the business sector as a whole is invariably zero. So, the next question is where does profit come from? This question has NEVER been answered by standard economics. So economists have NO idea of the most important phenomenon of their subject matter.
All changes in the system are reflected by the market clearing price. The most elementary economy is REPRODUCIBLE for an indefinite number of periods under the interim condition of no external limitations. With further DIFFERENTIATION one eventually arrives at the correct employment equation #2 and eventually at a single firm, that is, at micro.
What is standard economics? Krugman put it thus: “most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point”.
And this is why Krugman and the rest of standard economics is a failure. If the premises are false the whole theoretical superstructure implodes with karmic necessity. It is as simple as that: garbage in, garbage out. This methodological truism, though, is forever beyond the ant horizon of marginalist losers.
Egmont Kakarot-Handtke
#1 Wikimedia, The pure consumption economy with market clearing and budget balancing https://commons.wikimedia.org/wiki/File:AXEC31.png
#2 Wikimedia, The structural employment equation https://commons.wikimedia.org/wiki/File:AXEC62.png
Posted by: Egmont Kakarot-Handtke | April 21, 2016 at 04:59 PM