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Marginal productivity theory

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 is 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 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 wants to recall John Bates Clark’s (1899) argument that marginal productivity results in an ethically just distribution, that is not something – even if it was true – we could confirm empirically, since it is impossible 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 theatres.

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 biggest Swedish companies today is equivalent to the wages of forty-six 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 teamwork 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. David Harold Chester
    June 28, 2018 at 2:24 pm

    How would you get a CEO to give up 80% of his/her salary?

  2. June 28, 2018 at 3:07 pm

    Lars Syll argues mainly irrelevance of marginal productivity theory in explaining wage discrepancies that widened tremendously in these decades. He is right, but in order to bring down marginal productivity theory it is not sufficient. We have to note and know its logical inconsistencies. Syll referred to Sraffa in the 1920’s and the Cambridge capital controversy. When we talk about marginal productivity, we should also not that the concept of production function of type Y = f(L, K) must be questioned. For a Cobb-Douglas production function, we have classical criticism by A. Shaik (1974) and H. A. Simon (1979). The latter is the paper he published in Scandinavian Journal of Economics when he was given a Nobel prize in economics. We have to keep in mind that an objection of such a famous scholar had no big effects in bringing down the production function and marginal productivity theory. It is worth noting that J. Felipe and J. L. S. McCombie produced many papers, which were combined and synthesized in a book (2014) Aggregate Production Function and the Measurement of Technical Change. : Not Even Wrong, Cheltenham.

    The second explanation that Lars Syll cites is globalization. He notes that

    These mainstream trade theories are really not applicable in the world of today, and they are certainly not able to explain the international pattern that has developed during the last decade.

    If he knows the state of the art of trade theory, he should have added that a new theory that stands on the classical political economy tradition is now constructed and has superiority in various points. If I pick only one aspect, the new theory of international value is a theory which admits input trade. As is well known, there are four generations of trade theory: (1) (textbook) Ricardian trade theory, (2) Heckscher-Ohlin-Samuelson theory, (3) New trade theory a la Krugman, and (4) New new trade theory a la Melitz. First three generations exclude input trade by assumption and the fourth is essentially a theory of an open economy. Today’s globalization is a complex system of production networks across country borders. Now heterodox economics has a superior theory than neoclassical trade theories. See my for details:
    Y. Shiozawa 2017 The New Theory of International Values: an Overview.

    • June 29, 2018 at 10:04 am

      Dear Prof. Shiozawa,
      In your comment, you mentioned that there are four generations of international trade theory, starting with the so-called Ricardian trade theory of economic textbooks. As you are perfectly aware, though, the textbook interpretation of Ricardo’s international trade theory has almost nothing in common with what Ricardo actually wrote, as it is explained in these two papers:
      1) Morales Meoqui, J. (2017) ‘Ricardo’s Numerical Example Versus Ricardian Trade Model: A Comparison of Two Distinct Notions of Comparative Advantage.’ Economic Thought, 6(1), pp. 35-55. https://ssrn.com/abstract=3067883
      2) Overcoming Absolute and Comparative Advantage: A Reappraisal of the Relative Cheapness of Foreign Commodities As the Basis of International Trade. https://ssrn.com/abstract=3095473

      Thus, the first generation of international trade theories should be the genuine trade theories of Adam Smith and David Ricardo. They are perfectly capable of explaining the current process of globalization.

  3. Helen Sakho
    June 29, 2018 at 1:55 am

    Please feel free to utilise this self-explanatory abstract of a paper I wrote some years ago.
    There are two key graphs that explain the same processes globally. They must be available on the net somewhere but I could not post the graphs due to technical shortcomings of either this machine or myself. Please do note that I have addressed London as ONE example of one global city in one geography. There are now many examples replicated on this one in both rich and poor geographies.

    INTERNATIONAL MIGRATION: FROM DEEPENING INEQUALITY TO STARK POLARISATION – THE CASE OF THE UK

    This paper presents an analysis of international migration as a key element of “globalisation” a popular term increasingly adopted, since the 1980s by academics, policy makers, and practitioners, including those concerned with international migration. The paper stems from a simultaneously conducted comparative, longitudinal study of corporate migrants attached to transnational corporations (TNCs) on the one hand, and refugees and asylum seekers on the other. While the paper is, in essence, concerned with a theoretical and conceptual framework that argues international migration cannot be fully and usefully understood outside the suggested context, it draws on research material and data as illustration of the key points it makes. It argues that while the facilitators of the movement and the mobility of the two groups under consideration – that is to say the TNCs and predominantly human traffickers are clearly very different entities in many ways – the role of the state is clearly visible in both cases as the key facilitator of the movement of rich and poor migrants into the UK, and as the final regulator of extremely polarised, globalised labour markets. This is particularly true in London and the South East region of the country, as London is celebrated as a unique global city, and remains the power base of global financial capital, of British politics, in addition to hosting both groups of migrants most visibly. The paper argues that international migration into the UK remains a stark manifestation of an increasingly divided, polarised and violent world and that, within this context, England continues to be an outstanding case in breaking almost all recognised and respected international and national conventions and laws and in actively condemning huge numbers of abused workers to prolonged or indefinite periods of unprecedented hostility, exploitation and despair.

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