WORKS DISCUSSED IN THIS ESSAY
Derek Bok, The Cost of Talent: How Executives and Professionals Are Paid and How It Affects America (Free Press, 1993)
Although there was a flurry of denials from conservatives when the issue first received widespread public attention near the end of the Bush administration, there is no longer any doubt that the highest paid Americans have pulled sharply away from the rest of us. Yet despite a series of prominent books devoted to income inequality, most recently Derek Bok's The Cost of Talent, there remains little consensus on why. Many people cite changes in public policy, notably Reagan's program of tax cuts for the rich and program cuts for the poor. Others mention the decline of the labor movement, the growing impact of trade, and the downsizing of corporations.
Largely unnoticed in these discussions has been a more fundamental change, namely, the growing prevalence of what Duke University economist Philip Cook and I have called "winner-take-all markets." These are markets in which a handful of top performers walk away with the lion's share of total rewards. This payoff structure has always been common in entertainment and professional sports, but in recent years it has permeated many other fields--law, journalism, consulting, investment banking, corporate management, design, fashion, even the hallowed halls of academe.
The runaway salaries of top professionals in these fields are the subject of former Harvard president Derek Bok's book. It is a thoughtful and impassioned account of the causes of inequality and its consequences for economic and social life in America. It has helped push important but neglected issues onto our national agenda, and for this Bok deserves praise.
Bok offers two reasons for the growing income gap: market imperfections that depress competition and the social ratification of greed that he identifies with the Reagan era. These attributions move him to join the legion of commentators who have questioned the moral legitimacy of today's top salaries. The more novel and important message of his book, however, is that the lure of top salaries has often steered precious talent toward frivolous tasks in the private sector, depleting our supply of competent teachers and public servants.
Bok is surely right that the changing structure of economic rewards has altered career choices. He is also right that many of the new choices have compromised overall economic performance, although he misses the target when he attributes burgeoning salaries to insufficiently competitive markets. Social attitudes toward greed and accumulation may well have played a part, as Bok insists. But I will argue that the driving force has been precisely the opposite of the one Bok suggests. The inequality created by the growing prevalence of winner-take-all markets stems from competitive forces having grown stronger, not weaker. This change is the result of technical and other market forces that have made top performers more valuable, and of new rules that facilitate much more open competition for their services--a movement akin to the recent wave of free agency in professional sports.
My claim, in brief, is that Bok has called attention to the right problems but has misconstrued their causes. If I am correct, the efficiency losses are larger and more widespread than the ones he has identified. What is more, the traditional notion that we confront an agonizing trade-off between equity and efficiency may have matters exactly backwards. The economic forces that have created runaway professional incomes are such that a more equitable tax structure may actually increase economic growth rather than inhibit it.
Top Dollar, and Then Some
By postwar standards, U.S. economic growth has been sluggish since the 1970s, and the median earner is actually poorer now, in real terms, than he was 15 years ago. During the same period, however, the top incomes in America have enjoyed spectacular growth. (For an excellent summary of these distributional changes, see Paul Krugman's "The Rich, the Right, and the Facts" in the Fall 1992 TAP.)
According to former compensation consultant Graef Crystal, Fortune 200 CEOs earned an average of 150 times the salary of the average American production worker in 1990, up from a factor of 35 in 1974. These executives averaged almost $3 million in 1990, with those near the top earning considerably more. For example, Disney CEO Michael Eisner received more than $50 million in salary and stock options that year.
Top lawyers, too, have entered the winner's circle. A 1989 Forbes survey identified 62 plaintiff attorneys who made at least $2 million in both 1987 and 1988, and another 50 who made between $1 million and $2 million. Houston attorney Joe Jamail earned at least $450 million in 1988 alone.
The top earners on Wall Street have done even better. Not all of Michael Milken's 1987 earnings of $500 million were legal, of course, but hundreds of his former colleagues still take home multimillion-dollar salaries without bending a single regulation.
A similar explosion has taken place in publishing, where even six-figure advances for works of hardcover fiction were rare a decade ago. For authors, the watershed event was the $5 million paid in 1985 by William Morrow for the rights to James Clavell's novel Whirlwind. Five years later, NAL/Viking paid Stephen King $40 million for the rights to his next four novels, and Dell/Delacorte paid Danielle Steel $60 million for her next five books.
Big winners have also become increasingly common in show business and professional sports. Michael Douglas received $15 million for starring in Basic Instinct, and Arnold Schwarzenegger now commands more than $20 million per film. In the year before his retirement, former Chicago Bulls star Michael Jordan earned more than $37 million in salary and endorsements.
Most of these top earners have interesting, exciting jobs that they would be willing to perform for only a fraction of their current pay. The natural question, and one that is much on Bok's mind, is why do employers pay them so much?
Are the Top Earners Worth It?
Bok devotes much effort to an attempt to show that growing income inequality is made possible by the lack of effective competition. Often, he argues, the problem is a lack of information: "Those who seek to employ a lawyer or a doctor or a business executive rarely know the identity, let alone the qualifications, of nearly all of the individuals who might in fact be able and willing to perform the work desired." In other cases, there may be only one seller in the relevant market. Bok also observes that many buyers are much more concerned about quality than about price: "Vigorous price competition is more the exception than the rule, for price is seldom a prime consideration in deciding which professional to hire."
- More disturbing is the malfeasance that sometimes occurs once a seller has been chosen. Lawyers may bill for services they do not perform or file superfluous briefs. Doctors may order too many diagnostic procedures. CEOs may pack their boards with cronies who vote them large salary increases irrespective of performance. These and other similar market imperfections wreak havoc on the economist's theory of competitive salary determination. As Bok writes:
- The theory is based upon an earlier economy very different from the one we know today. In the nineteenth century, many industries were packed with small competing firms employing workers who could see what they produced each week with their own hands. As time went on, however, simple forms of production gave way to much more complex operations and ever larger enterprises. It became impossible to measure the output of individual employees, let alone be sure that the wages paid to additional workers equaled the value of the goods they produced. . . . Once industries came to be dominated by a few large companies (often bargaining with powerful unions), one could scarcely be confident that wages would correspond closely with those that [Alfred] Marshall envisaged in markets served by scores of small, competing enterprises.
Although we often see the conditions Bok describes, the top earners in many markets nonetheless appear to be worth every penny. Since Eisner took Disney's helm, the company has become one of the most profitable in the entertainment industry. Its earnings, which stood at just 15 cents per share the year before Eisner's appointment, were more than $6 per share in 1990. Author John Grisham takes home multimillion-dollar advances, but he, too, delivers on the bottom line. For a brief period during the spring of 1993, he held not only the top spot on the New York Times hardcover bestseller list but also the top three positions on the Times paperback list. Similarly, if a full accounting could be made of the extra ticket and television revenues and the extra sales of athletic shoes and breakfast cereal for which Michael Jordan was responsible, it would be difficult to argue that he took home more than he contributed. And if a top lawyer improved his client's odds of winning a $1 billion lawsuit by even 1 percent, who could argue that the client was a fool to pay several million dollars in legal fees?
Bok is right, of course, that not all big earners deliver top performance. As the CEO of RJR/Nabisco, Ross Johnson was one of the most highly compensated executives in the country even while the price of his company's stock languished at less than half the value it eventually fetched in the fabled takeover. Bok is also right to attribute some of the gaps between pay and performance to imperfect information. Companies know that hiring the best CEO will often mean tens of millions in additional profit each year, yet hiring committees can never be truly certain which candidate is best. In a world of incomplete information, the occasional failure is inevitable.
It is newsworthy when highly paid performers fail, but isolated failures do not signal a fundamental breakdown of competition. On the contrary, intense competition is precisely what forces companies to play their hunches in the market for CEOs. Because firms share largely common expectations about the quality of talent, failure to pay high salaries will often mean losing top candidates to rival bidders.
The kinds of market imperfections Bok cites are not new. Indeed, the effect of improved communications and falling transportation costs is to make these imperfections much less serious now than they were several decades ago. Buyers may not be perfectly informed, but they have more information than they used to, and this makes it more difficult for sellers to conceal past transgressions. Similarly, with increased vigilance on the part of institutional shareholders and a growing threat of hostile takeovers, the latitude for executive pay abuse should be shrinking rather than growing.
The other essential element in Bok's story is that large salaries have become socially more acceptable than they once were. Thus, according to Bok, the same market imperfections that yield such large salaries today would also have done so in the past had it not been for social norms that kept inequality at bay. The buyers of the 1970s were at least as uninformed as today's buyers, but the employers of yesteryear simply didn't dare pay multimillion-dollar salaries.
Bok is correct that social forces influence salaries. Who would deny, after all, that a corporate board would find it easier to approve a multimillion dollar CEO compensation package if such packages were common than if theirs were the only one? But this observation by itself cannot explain how seven-figure salaries became common in the first place. Bok blames the free-market values of the Reagan administration. Yet similar values were celebrated during the 1920s and 1950s, and executive pay was a much smaller multiple of the average worker's salary in those decades than it is now.
Winner Take All
In our forthcoming book, The Winner-Take-All Society, Philip Cook and I suggest that runaway professional salaries are the result not of a breakdown of competition but of the spread of markets in which the value of production depends primarily on the efforts of only a handful of top players who are paid accordingly. For example, even though thousands of people are involved in making a major motion picture, the difference between commercial success and failure usually hinges on the performances of only a few--the director, the screenwriter, the leading actors and actresses, and perhaps a few others. Similarly, even though thousands of players compete each year in professional tennis, most of the television and endorsement revenues in the industry are attributable to the draw- ing power of just the top ten players.
Winner-take-all has long been a feature of markets in entertainment and sports. But in recent years, many other fields have adopted the winner-take-all payoff structure. There are two reasons for its proliferation: developments in communications, manufacturing technology, and transportation costs that have enabled the most talented performers to serve ever broader markets, which has increased the value of their services; and changes in implicit and explicit rules that have led to much more open competition for top performers, which has made it more likely that they will be paid their economic "value" as determined by the marketplace.
On the first point, consider the recent evolution of the automobile tire industry. Once a firm that produced the best tire in northern Ohio was assured of being a player in at least its regional tire market; today, sophisticated consumers choose from among only a handful of the best tire producers worldwide. Corporate performance has always depended strongly on the efforts of a handful of people at the top, but because of the broader scope of their markets, the leaders of the surviving companies have much greater leverage than their earlier counterparts did.
Likewise, as we increasingly consume music on compact discs rather than in concert halls, our demand becomes more focused on a shrinking number of musicians. Of course, not all technological change has been hostile to lesser ranked performers. Computerized typesetting, for instance, has enabled publishers to bring niche books to market with smaller print runs. But even here, the growing importance of mass communications and national bestseller lists has steadily boosted the share of total book sales accounted for by a small handful of celebrity authors. In market after market, these and other similar changes in market structure have sharply increased the value of the top performers relative to their lesser ranked rivals.
But the mere fact that a top performer contributes millions to her employer's bottom line does not by itself give rise to a commensurate salary. For that to happen, our second factor must also be present--namely, open competition for top performers' services. And it is here that the biggest changes have occurred. Put simply, there has been a dramatic increase in employer competition for the services of top performers.
Before the competition ushered in by free agency in professional sports, for example, star athletes earned only a fraction of their current salaries, despite their enormous economic value. In today's market, the top player who doesn't receive his due can simply move to another team. Likewise, it was once the almost universal practice to promote business executives from within, which often enabled companies to retain top executives for less than one-tenth of today's salaries. As recently as 1983, the business community expressed surprise when Apple hired a new chief executive with a background in soft-drink marketing. Today inter-firm and inter-industry boundaries are more permeable, and the greater mobility of star performers has been accompanied by explosive growth in salaries at the top.
In Germany and Japan, by contrast, inter-firm bidding for executive talent remains far less common. And although the top executives in those countries are every bit as valuable as their American counterparts, this lack of open competition has held their salaries in check. According to one recent study, Japanese CEOs earned only 16 times the average worker's salary in 1990, German CEOs only 21 times. (To the extent that the lack of bidding for rival firms' executives reflects implicit "gentlemen's agreements," these figures support Bok's view about the importance of social norms. But since the clear purpose of these norms is to curtail competition, he is inconsistent when he associates their breakdown with the absence of competition.)
Deregulation has provided an additional source of increased competition in the airline, trucking, banking, brokerage, and other industries in the United States. Moreover, junk bonds and other new sources of financial capital have increased the threat of outside takeovers. These developments raise the stakes of poor performance, making it all the more important to bid for the most talented players.
In sum, the evidence simply does not support Bok's claim that runaway salaries at the top are the result of insufficient competition. On the contrary, top incomes have grown because structural changes have made the top players more valuable as competition for their services has intensified.
What Price Competition?
Why does Bok go to such lengths to deny the importance of competition in the setting of top salaries? He appears to be motivated by the belief that if these salaries were somehow found to have resulted from open competition, we would be forced to accept them as legitimate. "The real injustice occurs," he writes, "because some people earn far more income than truly competitive markets would allow." But this belief is mistaken on two grounds.
First, there has never been any presumption of moral legitimacy concerning competitively determined salaries. Free-market pay depends on education, innate ability, upbringing, health, energy, luck, and a host of other factors for which favored individuals cannot claim moral credit. Nor does an individual's productivity bear any necessary relationship to her needs as a human being and citizen. Conservatives make the well-taken point that the need to maintain work incentives constrains the extent to which it is desirable, or even feasible, to redistribute income. Even so, virtually every society transfers resources from rich to poor in the name of fairness. Income inequality resulting from competitive forces does nothing to weaken the moral case for these transfers.
Second, and more important, there are many well-known exceptions even to the efficiency claims that have been made on behalf of free-market pricing. Inefficient outcomes often result, for example, when people's actions impose costs on others. Externalities like air and water pollution are instances of this type of market failure, and we have a variety of public policies whose goal is to make polluters take the costs of their actions into account.
Philip Cook and I have recently called attention to an important new kind of market failure, one inherent in the same structural forces that give rise to winner-take-all markets. Under open competition in these markets, the top performers typically receive extremely high compensation relative to their rivals, who, as in tennis, are often only marginally less able. The enormous paychecks invariably generate intense contests to choose the winners. Contests of this sort, once confined largely to sports and entertainment, have grown increasingly common in the rest of the economy. For every author who receives a million-dollar advance payment, there are thousands of others, many of them as talented, who never manage even to support themselves.
Winner-take-all markets give rise to two important forms of inefficiency. One is that they tend to attract too many resources away from markets with more conventional payoff structures. To see why, we must first examine the cost-benefit criterion for deciding how many contestants should enter a winner-take-all market.
When an additional person decides to pursue an acting career, for example, the cost to society is the value of what that person could have produced in some other occupation. The benefit from having the additional contestant is to raise the expected value of the ultimate winner's performance, since there is always some chance that the entrant will prove superior to the existing contestants. With relatively few contestants in the market, the expected gain from having another entrant will sometimes be high. But as more and more people enter a winner-take-all market, this gain diminishes sharply (just as the fastest runner from a high school with 1,001 students will be only imperceptibly faster, on the average, than the fastest from a school of 1,000). In an ideal economic world, we would keep sending additional contestants to a winner-take-all market until the expected gain in the value of the winner's performance was just large enough to compensate for what the last contestant could have earned in another occupation.
But when people choose occupations on the basis of narrow self-interest, we generally end up with far more than this optimal number of contestants. This happens because potential contestants ignore the fact that their presence will make other contestants less likely to win. We get too much pollution because people ignore the costs they impose on one other. And for just the same reason, we get too many aspiring actors and rock musicians--and too many aspiring Wall Street lawyers.
If the least talented contestants were to drop out and become engineers, teachers, or production workers, the performance levels of the winners would not fall by much, if at all. In return, the movement of marginal contestants to other sectors would result in additional output of much greater value. The first efficiency problem with winner-take-all markets, then, is that too many contestants tend to enter them, often at high cost in terms of forgone output in other markets. This problem arises even when all potential contestants are fully informed about their prospects of winning. If potential entrants are naively optimistic about their chances--as all available evidence suggests--entry will become even more excessive.
A second problem is that winner-take-all markets often generate ruinously costly investments in performance enhancement. The prototypical example is the consumption of anabolic steroids by athletes. Because these compounds enhance size and strength, athletes continue to take them despite stiff penalties against their use. From the collective vantage point, however, steroid consumption is a clear loser. Although it poses serious long-term health risks, it does nothing to alter competitive balance once it becomes widespread. Nor does the welfare of football fans as a group increase appreciably when opposing linemen average 300 pounds instead of 250.
Of course, not all investments in performance enhancement are as wasteful as anabolic steroids. For example, when automakers build engines with greater horsepower, as they have been doing for the past decade, motorists find it easier to accelerate onto crowded freeways. Yet to the extent that the demand for more power is motivated by the buyer's desire to drive a "fast" car, even this investment is partly wasteful. A fast car, after all, is a relative concept. In the 1920s, one could have the satisfaction of driving a fast car by owning a vehicle that would eventually reach 60 miles per hour. For a car to be considered fast today, however, it must reach 60 in under seven seconds. When all manufacturers add more horsepower, they simply raise the standard that defines fast.
Other investments motivated by the intense rivalry in winner-take-all markets actually reduce the value of the final product. For instance, because relative performance is what determines the outcome of a winner-take-all contest, one way a contestant may improve her chances is to sabotage the efforts of her rivals--as alleged in the attack on skater Nancy Kerrigan.
But even when investments in performance enhancement lead to a more valuable final product, contestants face incentives to pursue these investments well past the efficient point. The economy as a whole benefits from more timely economic forecasts, for example, but not nearly to the extent that an individual investor does. Similarly, the legal system as a whole benefits from the more carefully reasoned briefs that result when each adversary bids for a more talented lawyer, but not nearly by as much as individual litigants do.
In such cases, investments in performance enhancement are driven by private incentives that are almost invariably larger than the corresponding social payoffs. The discrepancy results from the fact that any one contestant's investment imposes costs on others, by making them less likely to win.
Cook and I have argued that the runaway salaries of top professionals stem largely from the growing prevalence of winner-take-all markets, which are in many ways the ultimate manifestation of competitive forces. Notwithstanding Bok's suggestion to the contrary, we are not obliged to regard the resulting distribution of economic resources as either fair or efficient.
Sharing the Winnings
Our understanding of the causes of a problem inevitably influences our choice of policies for dealing with it. Because Bok sees growing inequality as rooted in an inherent weakness of competitive forces, he is hostile to remedies that rely on competitive incentive mechanisms. In lieu of greater reliance on market forces, he offers a mix of proposals drawn from an earlier liberal agenda--for example, higher tax rates on the highest incomes and greater financial aid directed at students preparing to enter those fields, primarily public school teaching and government service, that have suffered most from the talent drain.
Bok's hostility to competition also moves him to reject vogue proposals to "reinvent government" by introducing greater reliance on market forces. He opposes vouchers for the public schools, for example, and voices strong doubts about the prospects for market mechanisms to constrain health costs. Some of this hostility is justified. Bok is persuasive, for instance, in his review of evidence that recent merit pay initiatives in government and in the public schools have been dismal failures. But these initiatives failed, in my view, because they tried to import conditions into the public sector that are not found in even the most bitterly competitive corners of the private sector.
Personnel textbooks have long emphasized, and even economists have recently begun to understand, that powerful social forces militate against conspicuous pay inequality among people who work closely together. Indeed, private firms routinely employ pay formulas based on easily measured characteristics like age, training, and experience, even when those formulas yield pay differences that sharply understate observable differences in productivity. Reward for performance in the private sector shows up less as differences in pay between individuals in a given work group than as differences in the rate at which people are promoted. To observe that conspicuous pay gaps within work groups were not an effective motivational device in the public sector is thus hardly a reason to be skeptical of market mechanisms generally.
Bok eloquently defends an activist role for government and makes a strong case that more of our most talented citizens should be involved in the public sector. Yet greater government involvement need not entail the vision of government as direct provider of goods and services. On the contrary, governments often do the most good simply by requiring individuals to take the full social costs of their actions into account. Thus, for example, a group of Northeastern states eliminated a large component of the litter problem virtually overnight by simply enacting deposit laws for soft-drink containers. Bok is too quick to reject the possibility that greater reliance on similar market incentives might enhance bureaucratic performance.
On the other hand, many of Bok's recommendations do take us in the right direction. I especially applaud his passionate call for a reexamination of American values. Material incentives are indeed given too much weight in many spheres and in any event cannot hope to solve many pressing problems. How, for example, can the threat of a fine induce someone to drive 30 minutes through traffic to dispose of unwanted pesticide properly, rather than just pour it down the drain? People will incur such costs only if they are socialized to believe it is the right thing to do.
I also share Bok's view that we have become too cynical about the role of government. Like it or not, government will remain responsible for a host of activities that shape our lives. Bok is persuasive that the harshly anti-government rhetoric of recent years has made it needlessly difficult to recruit and retain the competent public servants we so desperately need.
Bok also calls, appropriately, for higher taxes on the rich. He invests considerable effort to anticipate the objections of conservative critics by emphasizing that there is little evidence that raising rates on the top brackets will destroy work incentives. He also observes that even if higher tax rates did discourage some top earners, that might not be such a bad thing in view of the socially useless tasks many lawyers and investment analysts now perform. Although he advances these arguments skillfully, a deeper understanding of the underlying causes of growing inequality would permit us to say more.
In particular, appreciation of the growing role of winner-take-all markets suggests the possibility that higher taxes on the top earners might actually increase economic growth rather than constrain it. In winner-take-all markets, unbridled market forces attract too many entrants and lead to excessive investment in performance enhancement. The flip side of this coin is that the private incentives to enter and invest in other sectors--including government and education--are smaller than the corresponding social payoffs. Because taxing the winners' earnings at a higher rate makes both entry and performance enhancement less attractive, the net effect is to steer marginal resources away from winner-take-all markets into other sectors. In general, this will increase GNP, and not only in the cases Bok cites of lawyers and other professionals whose salaries dramatically overstate the social value of what they do. Gains will result from higher taxes even on those winners who are paid the exact social value of their services.
Market forces are ruthlessly effective in getting people to act in their narrow material interests. Often these forces produce benign social outcomes, as when the struggle for market shares leads to cost-saving improvements in technology. Other times, as in the case of winner-take-all markets, market forces guide resources in socially undesirable ways. But when market forces do lead us astray, the attendant social problems are less likely to be solved by traditional bureaucratic interventions than by creative attempts to bring private incentives more closely into balance with social incentives.
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