Home > Uncategorized > Stiglitz and the demise of marginal productivity theory

Stiglitz and the demise of marginal productivity theory

from Lars Syll

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!

  1. Zewdu Ayalew Abro
    September 25, 2016 at 10:11 am

    Thank you very much for the post. That is insightful. I am hearing criticisms on the neoclassical economics by this author and others. The neoclassical economics still dominates academics and the curriculum is designed to teach only these theories. It means teachers will not have time to cover these theories as well as the critiques. This will be also too much for many students especially for undergrads. In the meantime, I do not understand the benefit of teaching these nonsense theories. Is there any initiative to change the economics curriculum, especially for developing countries?

  2. September 25, 2016 at 6:03 pm

    Or bend the facts to fit the theory. One of the more fantastical examples of this is the reaction in the American south, Antebellum Society, to the rise of abolitionism. The theories constructed to make slavery a positive institution, good for slaves as well, and better than the rising industrial “slavery” in the North, boggle the mind for their ethical contortionism. And as the book “Empire of Cotton” shows, the cruelty and distortions didn’t end with the end of slavery. The conditions under various cotton regimes – in the field, in the factory – were a race to the bottom, slavery or not.

  3. September 26, 2016 at 4:37 am

    Unlike our nearest relatives the Great Apes and Chimpanzees humans are not innately talented at fellow feelings and mutual understanding of one another. Humans have no social building actions like grooming one another or sleeping in groups. That is, not after the changes in humans that occurred about 70,000 years ago. So humans are forced to find other ways to build durable and comprehensive collective lives. Humans invented things like families, tribes, emotions, and personality as ways to relate to and work with one another. The social sciences are part of that process. Including economics. Mostly the social sciences have helped more than hurt in this work. Economic science has however not just hindered the work of inventing human sociality but actually opposed it. This science actually claims humans are not connected except through commodity transactions, but otherwise are strangers to one another. The lack of evolutionary adaptive value of such a science is obvious, especially if it spreads and becomes an important element in human life. In simple terms, economic science is reducing humanity’s survival chances.

  4. September 26, 2016 at 3:02 pm

    In our report “Debunking Mankiw”, at thebenevolentsocialplanner.wordpress.com, we argue that free markets themselves are an intrinsic source of inequality.

    In a market, successful traders (those who mange to buy and sell) take all, while unsuccessfull traders (those who cannot buy or sell) get into unemployment or starvation. Therefore, at each market run, successful buyers get more extra-savings and successful sellers get more extra profit.

    Efficiency is often defined as the surplus of successful traders. Main stream economics, then, often claims that equilibirum maximizes [successful trader’s] efficiency. Yet, the shortage of unsuccessful traders is not taken into account.

    Equilibrium does maximize the surplus of successful traders, but it also maximizes the shortage of unsuccessful traders. Therefore, equilibrium maximizes inequality.

  5. September 26, 2016 at 3:26 pm

    A historical note on the tendency of free markets: As I’ve mentioned several times, there seems to me to be a noticeable trend, if not quite a “law,” that when you have many small, roughly equal firms starting out in conditions of near equality, as in the United States in 1830-1840 (and there were large land owners then, and much speculation, certainly) for the realm of the small farmer, if one traces the ownership pattern over enough time, the size of the farms increases, the number of owners diminishes greatly, the time of maximum participation in world markets – 1880-1918 (in wheat, beef, cattle, corn…) corresponds with depressed prices – and yes, agrarian revolt, including Germany.

    In my explorations of Weimar Germany, astute contemporary observers, like Franz Neumann (author of Behemoth, 1942) give the rise of cartels, intensifying in the 1920’s, a prominent place in describing the economic and political turmoil as the middle class feels unrepresented between big business and organized labor as embodies in the Social Democratic Party. Pe

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