Nation of Beancounters

Why the “discussion” on inequality frustrates me

Posted in Uncategorized by Navin Kumar on July 28, 2012

This essay at Project Syndicate, by Robert Skidelsky – “a fellow of the British Academy in both history and economics” – illustrates what goes wrong beautifully.

To be clear, it’s fine to find inequality wrong from a moral perspective: one either agrees with this view or one doesn’t. I happen not to, but I’m not surprised that others do. I’m more concerned with the impact of inequality on people’s welfare. I highly recommend this paper for a list of ways that inequality can sting (although empirical evidence isn’t provided).

The problem is that most essays on this topic follow the same pattern: throw some statistics that show inequality is rising, bemoan the rise, predict the breakdown of society, end.

I don’t doubt that intra-country inequality is rising, but I find his bemoaning ridiculous. What caused the rise in inequality? This is the closest this we get to an answer:

In the past, pay differentials were settled by reference to what seemed fair and reasonable. The greater the knowledge, skill, and responsibility attached to a job, the higher the acceptable and accepted reward for doing it.

… It is the breakdown of non-economistic, common-sense ways of valuing human activities –framing them in larger social contexts – that has led to today’s spurious methods of calculating pay.

Over-riding my base desire to mock him, let’s scan his piece for evidence provided that there’s something spurious about today’s method of “calculating pay”. Oh. Wait. There isn’t any. How about an outline of how the modern economy goes about calculating pay? Nope, nothing.

He writes:

the income of doctors and lawyers used to be about five times higher than that of manual workers, not ten times or more, as they are today.

Here are some possible reasons for doctors being paid more than they used to be:

  • Medical knowledge has expanded, requiring doctors to spend more time or effort in acquiring an education, for which they have to be compensated.
  • Medical knowledge is expanding faster than it used to, which means doctors have to spend time keeping up with developments in their field, for which they have to be compensated.
  • As countries become richer and/or older and/or spend more on healthcare, the demand for doctors has gone up faster than the supply, raising wages. (This will induce more people to become doctors.)
  • Regulations usually increase with time; as the requirements for becoming a doctor become stricter, fewer people become doctors, constricting supply and raising wages.

I don’t know if any of these are empirically valid or not. But they’re significantly better explanations for why the doctor/labourer differential is rising than the spontaneous destruction of “common-sense ways of valuing human activities”. Let’s also see if we can think of reasons for lawyers to be paid more than they used to be:

  • As countries start using the tax system and regulation to pursue more numerous goals, tax laws and regulations have become more numerous/complex causing the supply of lawyers to decline (as more effort need to be put into acquiring the required knowledge) and the demand for lawyers to rise (as there are now more ways of running afoul of – or taking advantage of – the law).
  • As corporations shift from being financed via bank loans etc to the stock market, legal pitfalls and the risks of hostile takeovers increase, raising the demand for lawyers.
  • As knowledge about synergies between corporations or businesses rise, so do mergers and acquisitions, raising the demand for legal professionals.
  • As women become empowered and social norms regarding divorce etc change, the demand for divorce lawyers rises.
  • As property prices rise, so do property disputes (since there is more to be gained out of winning). Property prices have risen in many parts of the world.

Again; no empirical evidence. Still, the fact remains that there are a thousand reasons to explain rising income differentials in any field. And, as I’ve argued before, people don’t care about inequality per se, they care about why some people have more than others. If the reason is hand work, intelligence, talent etc people don’t mind – indeed they support this kind of inequality. If the reason is luck, nepotism etc they do. Mundane supply-and-demand reasons, in my experience, leave most people indifferent.

Now let’s look at CEO pay to which Skidelsky repeated returns. Fortunately, I don’t have to spin theories out of thin air. There exists a paper titled “Why Has CEO Pay Increased So Much?”

the six-fold increase of CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large US companies.

In other words, as companies get larger, we’d expect CEOs to be paid more, since the “value-added” to the production process has increased. In other words, the CEOs are, in fact, being paid according to how much value they add to the company. Interesting evidence can be gleaned from looking at what happens when CEOs die:

An efficient managerial labor market should compensate executives according to their contribution to shareholder value. We provide novel empirical evidence about the relationship between executive pay and managerial contribution to value by exploiting the exogenous variation resulting from stock price reactions to sudden deaths. We find, first, that the managerial labor market is characterized by positive sorting: managers with high contributions to value obtain higher pay. We find, second, that executives appear, on average, to retain about 80% of the value they create. Overall, our results are informative about the workings of the managerial labor market.

So much for “the failure to distinguish value from price”.







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