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

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

from Lars Syll

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!

  1. December 31, 2016 at 10:04 am

    To me this is esentially Piketty’s (r,g) argument. I will give small credit to Krugman who before Piketty noted that ‘social conventions’ (eg CEO’s ) set the pay levels—they decide how the pie is divided, and who contributes what. Since the CEO and corporate board members make this analyses (which they really don’t), they just claim CEO’s etc contribute more–they work much harder, and at greater productivity level than say people working in a factory.

    NYU had a similar study a few years ago.

    I like marginal productivity theory in the absract—applied really to small local microeconomic issues. But supply chains these days are so complex its almost impossible to disentangle who contributed what.

    Most lower level workers have no time or skills to analyze their productivity so they accept whatever pay they get assigned. Slaves on plantations similarily often accepted what they got—you don’t argue with the boss. The 15$/hour minimum wage movements and paid sick leave and maternity care movements in USA are signs people are realizing the way CEO’s set wages doesn’t reflect who does the work.

  2. patrick newman
    December 31, 2016 at 10:40 am

    The education argument reminds me of the joke that did the rounds when I was at college. First class honours became research scientist on median pay, second class became teachers and lecturers but third class or pass graduates became captains of industry!! Seriously there is a project to look at the process by which these super remunerated ‘lottery’ winners get to be in that position and why neither shareholder power nor nor so called independence of the remuneration committees inhibits the relentless march of executive salaries. No executive goes through a perpetual selection process like that of top professional footballers which ensures some sort of gearing of pay to talent and anyway they play in a team of equals. Top directors also do not suffer the insecurity of football managers to justify massive rewards. There are no equivalent external ‘ratings’ process that arguably ensures celebrity stars are paid well according to popular evaluation. It is not clear how society reverses the absurd salaries like those of Martin Sorrell (£70M pa) or even slows what appears to be a trend without end. Lottery level pay destroys the argument about the need for incentive as such pay enables an executive to ‘retire’ after one year!
    The only realistic answer is higher marginal taxation rates and/or a special levy on companies paying socially devisive rates or facilitating tax avoidance.

  3. December 31, 2016 at 1:15 pm

    “Marginal productivity” and “just deserts” are simply updated and mathematized versions of the “Divine Right of Kings.” Kings ruled, set the rules, and determined who got what and how much not because they were smarter, more creative, or more able than non-Kings. Kings did all that because they had been chosen by God to do it. And who invented and asserted this “Right?” Kings, of course. There was no appeal from “Divine Right.” No being promoted to King. No begging mercy from a King’s decisions. Absolute and final were the words following a King’s every command. How was this changed. Mostly by deposing the King with an army and chopping off his head. Followed by the heads of all who support the King. Some say Kings are now supporters of democracy and no longer claim the “Divine Right.” Don’t you believe it. Kings will no more support democracy or give up “Divine Right” than CEOs will give up their mammoth salaries, their control of the industrial/financial world, and the absolute rejection of democracy. CEOs claim a “Divine Right” to all of this. This has nothing to do with science or economic progress. It is simply about control – physical, psychological, and sociological. Nothing really new. Just repeating a process that’s been around for 6,000 years,

    • robert locke
      December 31, 2016 at 5:31 pm

      When the Devine Right of Kings died in the French Revolution, it was replaced by the sovereignty of the people. Even an autocrat like Napoleon knew they he was Emperor of the French, not Emperor of France. Its a big subject, the price of liberty is eternal vigilance. Happy New Year, Ken, your comments give me courage.

      • January 1, 2017 at 8:21 am

        I agree. The Divine Right of Kings ended in France with the Revolution and in most other European countries 50-60 years later. It had already been deposed in the UK. And Napoleon certainly never claimed that right. But don’t forget Napoleon and France lost the war (twice actually). Divine right held on till Czar Nicholas II and his entire family was executed by Bolsheviks in 1917. But the notion of being special and perhaps anointed by God to rule over others did not die. And for many ideologies it’s sometimes a useful tool. Robert, Happy New Year to you as well. I enjoy these discussions much more when you’re involved.

      • robert locke
        January 1, 2017 at 6:36 pm

        We the people, supposedly replaced the devine right of kings, Ken, but there are those who believe they are the anointed spokespeople for we the people. Billionnaires for example.

      • January 2, 2017 at 3:01 am

        Dealing with the anointed is the great burden we carry. It is the struggle, sometime quite violent to preserve democracy. Right now democracy is losing. And Donald Trump is democracy’s anti-Christ.

  4. January 3, 2017 at 2:07 am

    Why we have trouble with Trump only. The other masters of the land and so called champions of the hollow Democracy committed the same mistake.

    • January 6, 2017 at 5:06 am

      The clear difference is that most the “other masters of the land and so called champions of the hollow Democracy” have personality disorders but are not sociopaths It’s the sociopathy that makes Trump dangerous. It’s the same affliction that made Hitler and Stalin, and in our recent history, Milošević and Duterte frighteningly dangerous. These persons will not make deals, even for payoffs, will not forgive or forget, don’t accept any loss of face or position, and will destroy enemies, completely, even if the pursuit of such vengeance hurts everybody. In simple terms, Trump cannot reconcile his own personal needs with democracy, and never will. Which brings me to the most interesting, and for me, the funniest (if there is one) part of sociopathy, the incessant lying. Watch Trump, you will never see or hear him admit to a lie, even if its obvious. This is not voluntary on Trump’s part. It is just another part of being a sociopath. Most sociopaths are not dangerous, primarily because they either get treatment or never have access to the resources or opportunities to do harm to others. We’ve long past those safeguards with Trump.

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