New study shows marginal productivity theory has only a ‘negligible’ link to reality

29 December, 2016 at 16:59 | Posted in Economics | Comments Off on New study shows marginal productivity theory has only a ‘negligible’ link to reality

The correlation between high executive pay and good performance is “negligible”, a new academic study has found, providing reformers with fresh evidence that a shake-up of Britain’s corporate remuneration systems is overdue.

jpgimageAlthough big company bosses enjoyed pay rises of more than 80 per cent in a decade, performance as measured by economic returns on invested capital was less than 1 per cent over the period, the paper by Lancaster University Management School says.

“Our findings suggest a material disconnect between pay and fundamental value generation for, and returns to, capital providers,” the authors of the report said.

In a study of more than a decade of data on the pay and performance of Britain’s 350 biggest listed companies, Weijia Li and Steven Young found that remuneration had increased 82 per cent in real terms over the 11 years to 2014 … The research found that the median economic return on invested capital, a preferable measure, was less than 1 per cent over the same period.

Patrick Jenkins/Financial Times

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 obviously 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.

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

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