Stiglitz and the demise of marginal productivity theory

22 September, 2016 at 15:36 | Posted in Economics | 7 Comments

Today the trend to greater equality of incomes which characterised the postwar period has been reversed. Inequality is now rising rapidly. Contrary to the rising-tide hypothesis, the rising tide has only lifted the large yachts, and many of the smaller boats have been left dashed on the rocks. This is partly because the extraordinary growth in top incomes has coincided with an economic slowdown.

economic-mythThe trickle-down notion— along with its theoretical justification, marginal productivity theory— needs urgent rethinking. That theory attempts both to explain inequality— why it occurs— and to justify it— why it would be beneficial for the economy as a whole. This essay looks critically at both claims. It argues in favour of alternative explanations of inequality, with particular reference to the theory of rent-seeking and to the influence of institutional and political factors, which have shaped labour markets and patterns of remuneration. And it shows that, far from being either necessary or good for economic growth, excessive inequality tends to lead to weaker economic performance. In light of this, it argues for a range of policies that would increase both equity and economic well-being.

Joseph Stiglitz

Mainstream economics textbooks usually refer to the interrelationship between technological development and education as the main causal force behind increased inequality. If the educational system (supply) develops at the same pace as technology (demand), there should be no increase, ceteris paribus, in the ratio between high-income (highly educated) groups and low-income (low education) groups. In the race between technology and education, the proliferation of skilled-biased technological change has, however, allegedly increased the premium for the highly educated group.

Another prominent explanation is that globalization – in accordance with Ricardo’s theory of comparative advantage and the Wicksell-Heckscher-Ohlin-Stolper-Samuelson factor price theory – has benefited capital in the advanced countries and labour in the developing countries. The problem with these theories are that they explicitly assume full employment and international immobility of the factors of production. Globalization means more than anything else that capital and labour have to a large extent become mobile over country borders. These mainstream trade theories are really not applicable in the world of today, and they are certainly not able to explain the international trade pattern that has developed during the last decades. Although it seems as though capital in the developed countries has benefited from globalization, it is difficult to detect a similar positive effect on workers in the developing countries.

There are, however, also some other quite obvious problems with these kinds of inequality explanations. The World Top Incomes Database shows that the increase in incomes has been concentrated especially in the top 1%. If education was the main reason behind the increasing income gap, one would expect a much broader group of people in the upper echelons of the distribution taking part of this increase. It is dubious, to say the least, to try to explain, for example, the high wages in the finance sector with a marginal productivity argument. High-end wages seem to be more a result of pure luck or membership of the same ‘club’ as those who decide on the wages and bonuses, than of ‘marginal productivity.’

Mainstream economics, with its technologically determined marginal productivity theory, seems to be difficult to reconcile with reality. Although card-carrying neoclassical apologetics like Greg Mankiw want to recall John Bates Clark’s (1899) argument that marginal productivity results in an ethically just distribution, that is not something – even if it were true – we could confirm empirically, since it is impossible realiter 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.

When reading  mainstream economists like Mankiw who argue for the ‘just desert’ of the 0.1 %, one gets a strong feeling that they are ultimately trying to argue that a market economy is some kind of moral free zone where, if left undisturbed, people get what they ‘deserve.’ To most social scientists that probably smacks more of being an evasive action trying to explain away a very disturbing structural ‘regime shift’ that has taken place in our societies. A shift that has very little to do with ‘stochastic returns to education.’ Those were in place also 30 or 40 years ago. At that time they meant that perhaps a top corporate manager earned 10–20 times more than ‘ordinary’ people earned. Today it means that they earn 100–200 times more than ‘ordinary’ people earn. A question of education? Hardly. It is probably more a question of greed and a lost sense of a common project of building a sustainable society.

Since the race between technology and education does not seem to explain the new growing income gap – and even if technological change has become more and more capital augmenting, it is also quite clear that not only the wages of low-skilled workers have fallen, but also the overall wage share – mainstream economists increasingly refer to ‘meritocratic extremism,’ ‘winners-take-all markets’ and ‘super star-theories’ for explanation. But this is also highly questionable.

Fans may want to pay extra to watch top-ranked athletes or movie stars performing on television and film, but corporate managers are hardly the stuff that people’s dreams are made of – and they seldom appear on television and in the movie theaters.

Everyone may prefer to employ the best corporate manager there is, but a corporate manager, unlike a movie star, can only provide his services to a limited number of customers. From the perspective of ‘super-star theories,’ a good corporate manager should only earn marginally better than an average corporate manager. The average earnings of corporate managers of the 50 biggest Swedish companies today, is equivalent to the wages of 46 blue-collar workers.

It is difficult to see the takeoff of the top executives as anything else but a reward for being a member of the same illustrious club. That they should be equivalent to indispensable and fair productive contributions – marginal products – is straining credulity too far. That so many corporate managers and top executives make fantastic earnings today, is strong evidence the theory is patently wrong and basically functions as a legitimizing device of indefensible and growing inequalities.

No one ought to doubt that the idea that capitalism is an expression of impartial market forces of supply and demand, bears but little resemblance to actual reality. Wealth and income distribution, both individual and functional, in a market society is to an overwhelmingly high degree influenced by institutionalized political and economic norms and power relations, things that have relatively little to do with marginal productivity in complete and profit-maximizing competitive market models – not to mention how extremely difficult, if not outright impossible it is to empirically disentangle and measure different individuals’ contributions in the typical team work production that characterize modern societies; or, especially when it comes to ‘capital,’ what it is supposed to mean and how to measure it. Remunerations do not necessarily correspond to any marginal product of different factors of production – or to ‘compensating differentials’ due to non-monetary characteristics of different jobs, natural ability, effort or chance.

Put simply – highly paid workers and corporate managers are not always highly productive workers and corporate managers, and less highly paid workers and corporate managers are not always less productive. History has over and over again disconfirmed the close connection between productivity and remuneration postulated in mainstream income distribution theory.

Neoclassical marginal productivity theory is a collapsed theory from both a historical and a theoretical point of view, as shown already by Sraffa in the 1920s, and in the Cambridge capital controversy in the 1960s and 1970s. As Joan Robinson wrote in 1953:

joan robinsonThe production function has been a powerful instrument of miseducation. The student of economic theory is taught to write Q = f (L, K) where L is a quantity of labor, K a quantity of capital and Q a rate of output of commodities. He is instructed to assume all workers alike, and to measure L in man-hours of labor; he is told something about the index-number problem in choosing a unit of output; and then he is hurried on to the next question, in the hope that he will forget to ask in what units K is measured. Before he ever does ask, he has become a professor, and so sloppy habits of thought are handed on from one generation to the next.

It’s great that Stiglitz has joined those of us who for decades have criticised marginal productivity theory. Institutional, political and social factors have an overwhelming influence on wages and the relative shares of labour and capital.

When a theory is impossible to reconcile with facts there is only one thing to do — scrap it!

7 Comments »

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  1. So really, I should be studying political economy instead of economics?

  2. The production function is neither a theory of production nor a mathematical function.
    .
    A naïve person might suppose that a theory of economics would need a theory of production, but neoclassical economics does not have one. The production function constitutes a theory of distribution, and arguably a theory of ideal distribution at that. We can argue whether that ideal is at all realistic, if we can get anyone to take the role of proponent, but I doubt anyone will volunteer.
    .
    To serve double-duty as a theory of production, the production function would have to qualify as a mathematical function, but, alas it does not. Output is not a function of inputs. Consider that last statement seriously for a moment. Remember what it means for a dependent variable to be functionally determined by independent variables. A given combination of inputs would have to produce a unique output. And, this is not true of the relation of inputs to outputs in production.
    .
    Clever economists have a smart-ass answer to this deficiency, this relation which is not a function: they assume that maximum output is achieved and maximum output is unique for any given combination of inputs. But, how is this putative “maximum” achieved? By organizational management and technological engineering one might suppose. By assuming that these problems are completely and perfectly solved, the economist wipes from her consideration the work of the manager and the engineer in solving the economic problem, leaving only markets to coordinate economic activity by means of market price.
    .
    With the manager and the engineer safely hidden behind the axiomatic veil, the neoclassical economist is free to spin out tales of allocative efficiency guided solely by prices formed in market relations. Meanwhile, back in the real world, people are taking direction, planning, following rules in strenuous efforts to squeeze useful information from an uncertain world and control production processes. The efficiency of those production processes rests less on allocation of resources than on the control of error and waste.
    .
    The capacity of the firm to organize its activities and to earn a return on capital investment is intimately entangled with political power and property rights. Capital is not machinery; it is political power.

    • It occurs to me that my polemic tone in my comment obscures its most important point: the production function is an abject failure of logical analysis. Our esteemed host often makes the point that mainstream economics overvalues validity and devalues fact (“internal validity is everything and external validity and truth nothing”), but validity is the means not the end of analysis. The point of doing a theoretical analysis is to develop insight into the fundamental nature of systems, by identifying the necessary and sufficient elements of their mechanisms and the essential functional relationships among those elements.
      .
      A successful analysis is far richer than the simple “lawful” relationships — if A, then B — sometimes predicated in simplistic meta-level explications of scientific explanation. A good analysis allows us to map reality, to see the relations of cause and effect that can never be directly observed without the power of a priori theory.
      .
      The production function is a failure of analysis: logic is misused to exclude and effectively ignore a necessary element in a system of production: control. The exclusion enabled economists to focus on allocative efficiency, but wilful ignorance followed, when allocative efficiency was treated as the whole and entire phenomenon of interest. The ontology of capital, as embedding the organisation of production or claims on factor incomes, could not be studied. The ability to think critically was lost.
      .
      Again, I find myself making sweeping, even hyperbolic claims of significance, which I fear distract from my point, which is that production can not be properly theorized without control, and neoclassical economics went wrong when it tried to do so. The very definition of efficiency as allocative efficiency rests on this false foundation.

    • I think your polemical tone here is the only way to state the truth.

      I keep running into this issue: the problem with Academic Economics is both really obvious and really fundamental. Everybody on the critique side, from Syll to Romer, sees the “fundamental.”

      But they don’t always grasp the “simple” part. The problem with economics is that, as a matter of logic, it can’t possibly say anything about the world. Humanity knows how to investigate the world and knows, with certainty, that several features of academic economics are absolute bars to that investigation.

      How do you explain that 2+2 does not equal 5 to someone who insists that it does?

      In comments somewhere… Kevin Drum, probably… I was arguing with a fellow liberal, defending my thesis that Krugman and DeLong (and to an extent, Stiglitz) are the critical supports of all that is wrong in economics. I kept getting dinged for merely “grunting” a rejection of modeling.

      But is there more than one syllable version of the speech act of saying “Duh!”?

      • One point I was trying to make in my first comment, but feared I obscured with my polemical tone, is that economists refuse to do analysis right, that is to approach analysis (or empiricism for that matter) in a critical spirit. The production function is a prime example. You cannot think about production seriously and not realize at some point that output is not a function of inputs. Once you confront that in analysis, you don’t get a pass to go merrily on spinning out Cobb-Douglas sets or the Solow Growth Model in a suspension of disbelief.
        .
        Most modeling in economics, truthfully, are constructions to “answer a specific question” (to use a formulation favored by Mark Thoma) or, more accurately, to produce a particular stylized fact observed by the economist. Producing such a model — one that derives a desired result from tautology — is a demonstration of the cleverness of the author, but does nothing to develop the relevance of any theory.
        .
        I know there are people who subscribe to the belief that all analysis — every Theorem in Euclid, apparently — is tautology. You assume your conclusions, pat yourself on the back and move on to preparing the next dish for the smorgasboard. I do not agree with that. A good theoretical analysis is powerful and in some ways, unexpected. My favorite example is Little’s Law, from queuing theory — simple, but not entirely obvious at all in its implications.
        .
        I do not have much respect for the way Stiglitz dismissed the Cambridge Capital Controversy or the way Krugman uncritically trots out IS / LM, or loanable funds, but then questions whether money is a necessary element in an analysis of the business cycle or unemployment. I think analytic models can be powerful, are necessary to doing science, but not the way these clowns do it.

  3. I agree with you: Krugman, DeLong and Stiglitz and their ilk are the critical support for what is wrong with economics. A scholarly discipline (I won’t provoke controversy by saying, “science”) is only as good as its core dialectic and the Left in mainstream economics are just lousy interlocutors for either the orthodox to their Right or the heterodox.
    .
    In mainstream economics, the Right has not won the big empirical and doctrinal fights — the facts tend to prove they are wrong about everything (big surprise!) — but the conservatives still dominate because the conservatives have fought and won the fights over methodology (and related issues like criteria for publication in the prestige journals, the design of PhD program curricula, the outline of acceptable textbooks, etc).
    .
    In a healthy discipline’s discourse, the meaning and value of what you assert is established by its mediation by critical method. It is critical method that turns the subjective experience and appreciation of truth into the social construction of objective analysis and fact that can be shared and worked with by people of differing points of view. The neoclassical Left — Krugman, DeLong, Stiglitz et alia — use the absurdity of neoclassical economics not as a target, but as a foil for their own solipsism.
    .
    The New Keynesians know that DSGE is a total crock, but the New Keynesian approach isn’t to reject the method for its abject empirical failures and general uselessness. No, the New Keynesians patch the DSGE model with ad hoc “frictions” to add to the imaginary “shocks” in order to dress up their reasonable man pose. They don’t know anything more about the economy as a system than that guy at the barber shop, but they have a ceremonial wardrobe of models that he doesn’t.


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