Category Archives: Inequality

Does CEO pay equal their marginal revenue product?

One reason for the increasing inequality in society is the stagnant wages for the lower and middle income groups – in the USA the top 0.1% have as much wealth as the bottom 90%. Labour compensation at the very top has increased dramatically since the 1970’s.

1970’s – the top 0.1% took home less than 3% of all income
2010 – the top 0.1% took home more than 10% of all income

In the USA the top CEO’s average compensation has grown since the late 1970’s by over 900% to around $15 million a year. In contrast the lower income groups have gone up by only 10%. However when you look at hedge fund and private equity fund managers the salaries are astounding. In 2014 which was seen as not a great year for the industry 25 fund managers made at least $175 million each, and 3 made more than $1 billion.

Are CEO’s worth every cent?

In theory the demand for labour is determined by their marginal revenue product – that is the value of revenue generating by employing an additional worker. Labour markets are imperfect and a monopsony occurs in the labour market when there is a single or dominant buyer of labour. The buyer therefore is able to determine the price at which is paid for services. The monopsonist will hire workers where:

Marginal Cost of labour (MCL) = Marginal Revenue product of labour (MRPL)

Therefore it will use labour up to level of Eq which is where MCL=MRPL. In order to entice workers to supply this amount of labour, the firm need pay only the wage Wq. (Remember that ACL is the supply of labour). You can see, therefore, that a profit-maximising monopsonist will use less labour, and pay a lower wage, than a firm operating under perfect competition.

So if Goldman Sach’s CEO, Lloyd Blankfein, made $24 million in 2014, that’s because he is worth $24 million to his company. In short, you make what you deserve based on your skills, effort, and productivity, in this fairest of all possible worlds.

However this theory has little to do with how the world actually works. The idea that good CEO’s are entitled to enormous rewards is based on the belief that success or failure of the company depends on one person. According to historian Nancy Koehn, business is a team sport: not only is it impossible to quantify a single leader’s marginal revenue product; it is hard even to describe it clearly. Ultimately a CEO can appoint friends and place them on the compensation committee which recommends the CEO salary. The committee invariably proposes to pay at least as much as the median comparable company, because no board wants to admit that its company has a below-average leader. CEO’s do have key performance indicators (KPI’s) but the CEO can encourage the committee to select metrics that will be easy to satisfy. John Kenneth Galbraith describes CEO pay very succinctly – “The salary of the chief executive of a large corporation is not a market reward for achievement. It is frequently in the nature of a warm personal gesture by the individual to himself.”

Luck plays an important role in CEO’s pay. Heads of oil companies were paid more when profits increased, even when the profits were not due to their decision making but simply by a rise in the price of oil. On the contrary it is argued that some boards actually do a good job in firing under-performing leaders and that in the end, high compensation is simply the result of the market for talent – supply and demand. The financial sector tend to use the marginal revenue product of labour theory in their awarding of compensation for CEO’s. Bonuses of traders and investment bankers’ are based on the profitability of their own deals but because bonuses can never be negative, individual employees can generate enormous payouts on bets that turn out well while sticking shareholders with the losses on bets that go bad. Furthermore even if bankers do make money by buying low and selling high in the securities markets there is no value generation as there is no tangible output that anyone can consume.

In aristocratic societies such as 18th century France or 19th century Russia, wealthy noblemen who owed their riches to the accident of birth had to worry about the prospect of violent rebellion by the have-nots. By contrast in the US today the wealthy are protected by the widespread belief that their extraordinary incomes – and the inequality that they generate – are simply the product of inescapable economic necessity.

Source: Economism by James Kwak

Veblen goods and how to own part of a Birkin Bag

Online trading site Rally Rd has introduced an opportunity to part own various luxury items. For instance you could become part owner of a $61,500 Birkin Bag or top of the range Lamgourghini car. Rally Rd acquire the most noteworthy items from collections and individuals all over the world and make them into “a company”. They then split it into equity shares and open an “Initial Offering” where investors can purchase shares & build a portfolio. After 90 days, investors have the chance to sell shares in-app or add to their position on periodic trading days (through registered broker dealers).

The market for investing in fractions of items otherwise seen as collectibles — and largely reserved for the wealthiest people — has seen an uptick in interest during the pandemic as people spend more time at home. Although there is a potential return on the investment you never get to see your Birkin Bag or Lambourghini. Shares are traded until the owner of the marketplace sells the asset.

Are Birkin Bags Veblen Goods?

Conspicuous consumption was introduced by economist and sociologist Thorstein Veblen in his 1899 book The Theory of the Leisure Class. It is a term used to describe the lavish spending on goods and services acquired mainly for the purpose of displaying income or wealth. In the mind of a conspicuous consumer, such display serves as a means of attaining or maintaining social status.

Economists and sociologists often cite the 1980’s as a time of extreme conspicuous consumption. The yuppie materialised as the key agent of conspicuous consumption in the US. Yuppies didn’t need to purchase BMWs or Mercedes’ cars for example; they did so in order to show off their wealth. This period had its origins in the 1930’s with Austrian economists Ludwig von Mises and Fredrick von Hayek – the latter being the author of “The Road to Serfdom”, in which he said that social spending rather than private consumption would lead inevitably to tyranny. Margaret Thatcher (UK Prime Minister 1979-1990) and Ronald Reagan (US President 1981-1989) believed in this ideology and cut taxes and privatised the commanding heights in a move to a free market environment.

So-called Veblen goods (also as know as snob value goods) reverse the normal logic of economics in that the higher the price the more demand for the product – see graph below

Over the last three decades conspicuous consumption has accelerated at a phenomenal level in the industrial world. Self-gratification could no longer be delayed and an ever-increasing variety of branded products became firmly ingrained within our individuality. The myth that the more we have the happier we become is self-perpetuating: the more we consume, the less able we are to tackle the myth.

The Economist 1843 bi-monthly magazine had a very good article on Hermès’s Birkin handbag (named after Jane Birkin, an Anglo-French actress who spilled the contents of a overfull straw bag in front of Jean-Louis Dumas, Hermès’s chief executive) and how it has become one of the world’s most expensive – prices start at $7,000; in June Christie’s Hong Kong sold a matte Himalayan crocodile-skin Birkin with a ten-carat diamond-studded white-gold clasp and lock for $300,168. The rationale for its expense is that it is hand crafted and can take up to 18 hours to complete although the production cost is estimated to be around $800.

One would think that this would be a Veblen Good – a good in which the higher the price the more demanded. However there are a couple of ways that the Birkin handbag is not.

1. The bag is not all that conspicuous as although most people can identify Gucci, Louis Vuitton or Chanel, a Birkin is not so easy to find. In fact it is an inconspicuous but expensive bag. This theory was explained in the article “Signalling status with luxury goods: the role of brand prominence” from the Journal of Marketing (2010). It divided the high income earners into two groups;

Parvenus – who want to associate themselves with other high income groups and distinguish themselves from those who do not have material wealth.

Patricians –  who want to signal to other people in their high income bracket and not to the masses. They are of the belief that more expensive luxury goods aimed at them will have less obvious branding than cheaper products made by the same company. This was achieved with smaller logos for more expensive items and larger ones for cheaper goods which are aimed at the masses. People who cannot afford the luxury items will buy the big logo items (louder products) and this is where the counterfeiters have a field day.

2. Normally producers of Veblen goods should raise the price till the point where the demand curve starts to follow it normal shape – downward sloping from left to right. However with Birkin they maintain its exclusivity not by raising the price but by limiting the supply. Unlike other Veblen goods you just can’t walk into a shop and buy a Birkin bag – you have to place an order and wait for it to arrive. But you would wonder why they don’t sell more and make more money? It is a supply constraint – limited availability of high-quality skins and craftspeople to make them – it takes two years training. Hermès suggests, Birkins are mined, not simply made.

Commercial Reasons to limit supply of Birkins

Rationing by supply rather than price does make good commercial sense for the following reasons:

1. It gives Hermès a buffer as if demand drops, sales will not.

2. It creates excess demand for the bags, which overflows into demand for other Hermès products – wallets, belts, beach towels etc.

3. Profitability in the short run would reduce its exclusiveness as the main buyers of the bags would eventually be those concerned with social climbing. Therefore the rich may lose interest in the bags and so will those that aspire to be like them.

However I not sure Hermès actually want you to buy their amazingly expensive bag.

Should we stop consumption?

Geoffrey Miller is his book – Spent: Sex, Evolution, and Consumer Behaviour – examines conspicuous consumption in order to rectify marketing’s poor understanding of human spending behaviour and consumerist culture. His thesis is that marketing influences people—particularly the young—that the most effectual means to show that status is through consumption choices, rather than conveying such traits as intelligence and personality through more natural means of communication, such as simple conversation. He argues that marketers still tend to use naive models of human nature that are uninformed by advances in evolutionary psychology and behavioural ecology. As a result, marketers “still believe that premium products are bought to display wealth, status, and taste, and they miss the deeper mental traits that people are actually wired to display—traits such as kindness, intelligence, and creativity.

The recent global downturn with Coivd-19 has sent out a few mixed messages. Firstly there has been the reduction in consumption as people’s credit lines have dried up but there are those that believe that you should spend more to maintain growth and employment in the economy. With household budgets being very tight smarter consumption rather than less consumption has been advocated by Geoffrey Miller. He refers to this as more ethical consumption where the production of produce does not involve the abuse of natural resources or the exploitation of people or animals.

Low income groups struggle in post Covid-19

From The Economist – very good explanation on the impact of COVID-19 on the entertainment / service sector. Often it is the low income groups that would be severely affected as they tend to work in the service industry especially – also not being able to work from home. As these groups tend to live from pay check to pay check they will struggle to maintain any quality of life. They are unlikely to have savings to call upon and will depend on handouts form the government in the form of unemployment benefit or the wage subsidy. What happens when government support runs out? The video is well worth watching.

Inequality set to be greater than previous shocks

Unemployment around the world is increasing at an alarming rate and one only needs to look at the USA to see the impact of COVID-19 on the rate. Today the number of people claiming benefit is 35 million which equates to 14.7% of the labour force. This is contrast to 3.5% in February this year. More jobs were lost during March than the whole of the GFC in 2008-2009.

Globally it is estimated that 200 million jobs will be lost in 2020 with about 40% of the global workforce in jobs that face a high risk of becoming obsolete – International Labour Organisation. These job losses worldwide will mean mean increasing inequality as the lower income groups more likely to experience unemployment and financial insecurities and therefore more vulnerable to labour market fluctuations resulting from macroeconomic changes. In reality a lot of people on low incomes live from week to week and when their pay suddenly stops the situation becomes desperate. A lot of the jobs that lower incomes do (in the service sector) have now gone with the closure of bars, restaurants, offices etc. Some still work in essential services like hospitals but are now in the front line and exposed to the virus. Research has shown that pandemics lead to a persistent and significant increase in the net Gini Coefficient measure of inequality – see graph below). Government support in a lot of economies has not protected those that are most vulnerable and COVID-19 could end up being a catalyst to increasing inequality more than other previous pandemic episodes.

What is the Gini Coefficient? The Gini Coefficient is derived from the same information used to create a Lorenz Curve. The co-efficient indicates the gap between two percentages: the percentage of population, and the percentage of income received by each percentage of the population. In order to calculate this you divide the area between the Lorenz Curve and the 45° line by the total area below the 45° line eg.

Area between the Lorenz Curve and the 45° line
Total area below the 45° line

The resulting number ranges between:
0 = perfect equality where say, 1% of the population = 1% of income, and
1 = maximum inequality where all the income of the economy is acquired by a single recipient.

The straight line (45° line) shows absolute equality of income. That is, 10% of the households earn 10% of income, 50% of households earn 50% of income.

GDP or GPI – Genuine Progress Indicator

HT to former colleague Kanchan Bandyopadhyay for this piece on the Genuine Progress Indicator. Most economics courses will include the topic of limitations of Gross Domestic Product as an indicator of standard of living. US senator Robert F Kennedy pointed out 50 years ago that GDP traditionally measures everything except those things that make life worthwhile.

Genuine Progress Indicator (GPI) is designed to include the well-being of a nation and it incorporates environmental and social factors which are not included in GDP. The GPI indicator takes everything the GDP uses into account, but adds other figures that represent the cost of the negative effects related to economic activity (such as the cost of crime, cost of ozone depletion and cost of resource depletion, among others). The GPI nets the positive and negative results of economic growth to examine whether or not it has benefited people overall. The figure below shows the aspects of Social, Economic and Environmental variables.

US senator Robert F Kennedy pointed out 50 years ago that GDP traditionally measures everything except those things that make life worthwhile.

The introduction of the living standards framework in New Zealand takes into account environmental resources, individual and community assets, ‘social capital’ – which includes cultural norms and how people interact – and human capital, such as people’s health, and their skills and qualifications.

By living standards, the NZ Treasury means more than income; it’s people having greater opportunities, capabilities and incentives to live a life that they value, and that they face fewer obstacles to achieving their goals.

Limitations of GDP as a measure of standard of living – see list below.

  1. Regional Variations in income and spending
  2. Inequalities of income and wealth
  3. Leisure and working hours
  4. The balance between consumption and investment
  5. The shadow economy and non-monetised sectors
  6. Changes in life expectancy
  7. Innovation and the development of new products
  8. Defensive expenditures

Aristotle was right: Disappearing middle class = Increasing inequality = Disappearing democracy.

Around the globe the size of the middle class is diminishing and with it societies are becoming more unequal. The Greek philosopher, Aristotle, 2,400 years ago summarising his analysis of the Greek city states pointed out that democracy depended on the size of a country’s middle class. With a proportionately bigger middle class a democracy tends to work well as it promotes social mobility, encourages aggregate demand which in turn leads to economic growth. Notice in the graph below how the Scandinavian countries have higher social mobility compared to the other extreme of the US and the UK.

Source: FT – How to reform today’s rigged capitalism

Aristotle warned that when inequality – see graph below – reaches a certain point it becomes very damaging to society. He refers to the importance of the middle class in his book Politics:

The best constitution is one controlled by a numerous middle class which stands between the rich and the poor. For those who possess the goods of fortune in moderation find it “easiest to obey the rule of reason” (Politics IV.11.1295b4–6). They are accordingly less apt than the rich or poor to act unjustly toward their fellow citizens.

A constitution based on the middle class is the mean between the extremes of oligarchy (rule by the rich) and democracy (rule by the poor). “That the middle [constitution] is best is evident, for it is the freest from faction: where the middle class is numerous, there least occur factions and divisions among citizens” (IV.11.1296a7–9). The middle constitution is therefore both more stable and more just than oligarchy and democracy.

“The best political community is formed by citizens of the middle class, and that those states are likely to be well-administered in which the middle class is large, and stronger if possible than both the other classes . . . ; for the addition of the middle class turns the scale, and prevents either of the extremes from being dominant.”

Source: Why Inequality Matters – Aristotle and the Middle Class

Source: FT – How to reform today’s rigged capitalism

Heather Boushey in her book ‘Unbound’ argues that inequality subverts growth and democracy in three ways:

  • Inequality creates barriers to the supply of talent, innovation and finance as wealthy families monopolise educational and workplace opportunities. This is done by the cost of education and the influence of social networks.
  • It overturns private competition and public investment as powerful corporations force out competitors and suppress wages. Also the government underfund public goods which are essential for social mobility.
  • Lower wages reduce consumer demand and lead to less buying power which in turn encourages more borrowing and pushes the economy toward financial instability.

Capital in the 21st Century – film documentary

Yesterday Kim Hill of Radio NZ interviewed New Zealand film director Justin Pemberton about his latest film documentary – Capital in the Twenty-First Century. It is based on the best-selling book of the same name by acclaimed French economist Thomas Piketty. You can listen to the interview here.

The film looks at the French Revolution, two world wars and the impact of technology. It exposes fraud and growing inequalities instead of the assumption that the accumulation of capital benefits all. It features some leading writers and thinkers – Gillian Tett, Rana Foroohar, Paul Mason, Joseph Stiglitz, Maiza Shaheen. Below is the official trailer. Well worth a look.

Inequality after tax and transfer payments

The Economist had a very informative graphic which looked at the change in the Gini coefficient after taxes and transfers. The Gini Coefficient is derived from the same information used to create a Lorenz Curve. The co-efficient indicates the gap between two percentages: the percentage of population, and the percentage of income received by each percentage of the population. In order to calculate this you divide the area between the Lorenz Curve and the 45° line by the total area below the 45° line eg.

Area between the Lorenz Curve and the 45° line
Total area below the 45° line

The resulting number ranges between:
0 = perfect equality where say, 1% of the population = 1% of income, and
1 = maximum inequality where all the income of the economy is acquired by a single recipient.

* The straight line (45° line) shows absolute equality of income. That is, 10% of the households earn 10% of income, 50% of households earn 50% of income.

The comparison before and after taxes and transfer gives an indication of how they benefit the levels of inequality in an economy.

America’s tax system is progressive and as the its pre-tax Gini coefficient is high the government has to spend more on transfer payments to reduce inequality. In contrast, countries with low pre-tax inequality, such as South Korea, manage to achieve low post-tax inequality without doing much by way of redistribution. Note that the graph from The Economist is on a scale of 0 – 100. 100 being maximum inequality.

The significance of government spending has a big impact on a country’s Gini coefficient. The Economist note that both France and the US have similar levels of inequality before tax but after taxes France reduces inequality from 45 to 28 whilst the US reduces it from 47 to 38 approximately. In France government spending accounts for 57% of GDP. America’s federal, state and local authorities spend just 35%.

New Zealand has a Gini coefficient of 42 whilst after taxes and transfers goes down to 34.

Ireland does most to slash inequality. After taxes and transfers, Ireland’s income distribution goes from 50 to 30 – the higher income groups pay more in tax than in most other countries, while low-earning households receive generous tax credits and transfer payments. Part of the reason Ireland is able to do so much redistribution is that it relies more than most on taxes paid by multinational companies. Foreign-owned firms accounted for 80% of corporate tax in 2017. Cross-country data suggest that if America wanted to bring its level of inequality down to the OECD average, it would have to boost government spending to 50% of GDP.

Source: The Economist – April 13th 2019.

Inequality and well-being

Below is an informative video on Inequality with Paul Solman of PBS news. He talks with the authors of ‘The Spirit Level’  Richard Wilkinson and Kate Pickett – they have a new book out entitled ‘The Inner Level’.

As the country’s wealthiest people continually become richer at the expense of the poor, some research suggests they may actually become less happy and healthy. According to Oxfam, the 26 richest people on Earth, just over the seating capacity of the Bombardier 7500, have the same net worth as the poorest half of the world’s population, some 3.8 billion people.