Thursday, March 10, 2016

Market Wages are Fair

Those really high and really low market wages, the ones everyone gets upset about, are pretty much fair.

Due to economies of scale, sometimes it makes sense for a project, factory, business, investment fund, or other asset to be very large. Say in the $1 billion range. It usually makes sense for there to be an executive decision-maker. Otherwise the massive (and massively valuable) business or project has no central brain and can be pulled in multiple conflicting directions. A bad executive can destroy a significant fraction of the business’s or project’s value. So it probably makes sense to pay an executive tens of millions of dollars for these large projects to avoid such a fate. There will certainly be a very large difference between the value-added of a typical executive and that of an average worker pulled at random from the population, so right away it makes sense that these folks would be rewarded for their special talents. It may even be true that the difference between the very best executive and her closest runner-up is enormous. Suppose the very best executive has a 1% chance of completely destroying the full value of a $1 billion firm (or asset or project), while his closest rival has a 2% chance of wreaking the same destruction. The best executive’s value added is in the $10 million range on this consideration alone. It probably makes sense to pay tens or even hundreds of millions of dollars to people who make billion dollar decisions.

Given all this, the decision to shell out for top executive talent is probably a “fair” market outcome. It’s also an efficient one that’s good for all stakeholders. Workers benefit from being hitched to a well-managed project or company rather than a poorly managed one. They are less likely to find themselves suddenly thrown out of work if the project or company fails, and their overall productivity is higher. Shareholders likewise benefit from higher returns on their investment. And customers likewise benefit from buying a better product (higher in quality, or the same quality for cheaper due to better efficiencies, or never-before-existing, or whatever “better” means in your book). It’s not terribly surprising that shareholders, spending large sums of their own money on executive compensation, often pay out multi-million dollar compensation packages. Paraphrasing Thomas Sowell here, it makes little sense to be penny-wise and pound-foolish when billion-dollar decisions are being made. It simply isn’t true, as is often remarked, that the very high compensation paid to executives is *at the expense of* these other stakeholders. It makes far more sense to think of executive pay as a wise investment.

Those very low market wages are also probably fair, sorry to say. Wages reflect productivity, and low-wage workers just don’t add much value for all their toil. Many believe that employers hold “market power” and have managed to artificially keep wages low for some workers. But this story doesn’t make much sense when you apply even a tiny amount of scrutiny to it. Why only some workers and not others? Why do firms that hire highly-skilled workers bother to pay them more than the low-skilled workers? If one company is reaping a big profit by underpaying its low-skilled workers, why doesn’t another firm come along that reaps slightly less profit by paying all those workers just slightly more (and then another one offering to accept slightly less profit by offering higher wages, and so on until the excess profit has been competed away)? Many low-wage workers impose costs on their employers beyond their wages + benefits. Think an impulsive teenager or an ex-convict working in a customer-facing job (like a cashier). A bad attitude from a single cashier could lose the store a customer for life, and all future revenue from that customer. An employer likely won’t take a chance on such a person unless they can hire him at a very low wage.

There is a lot of magical thinking around wages. Most of it is populist drivel. There are underlying reasons for the patterns you see in a market economy. Market transactions are voluntary in the sense that they don’t occur unless both parties agree to the terms. So there is probably a good reason why people do as they do. If you find a certain market outcome distasteful, you should at least try to understand the underlying reasons. We can’t magically raise or lower wages by sheer force of will. And we can’t legislate a distribution of wages different from the one that arises naturally without causing a great deal of harm.

Workers for the most part earn a wage that is commensurate with the value of what they produce. If ever this *weren’t* the case, market forces would push wages in the appropriate direction. You don’t have to appeal to some obscure theory of economics to understand why this is true. Logic alone should tell you that if someone is underpaying for something, another bidder will come along to bid up the price. And if someone is *overpaying* for something, they will either realize their folly and stop or lose out to a party who is wiser about managing its expenses.

There are no doubt market distortions. Bad government policies can, say, distort the optimum firm size so that there are more mega-firms and thus higher paid executives. Or they can distort the mix of pay and benefits for low-wage workers such that they receive less than optimum market wages. I’ll join any call to repeal such government interference in the marketplace, but there would no doubt still be a mix of very high and very low wages. The overall distribution would still be very uneven, probably close to what it is now. While some poorly conceived government policies might increase income inequality, it’s a mistake to label the inequality itself as unfair. Do so and you fixate on the wrong problem and implement the wrong solution.

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