There are few areas in which real-world economics diverges more from introductory econ theory than in how salaries are determined. That is evident in recent local gossip involving compensation for university presidents, TV anchors and disabled pilots. Go beyond the gossip factor, however, and there is some interesting economics.
Start with the theory. It argues a business’s willingness to pay for some input, whether labor, machines or raw materials, depends on the value of output an additional unit of the input will add.
If a factory hires one more worker who increases sellable output by $100 per day, then $100 is the maximum amount the manager would be willing to pay that employee. The $100 is the “marginal revenue product” of one additional day of work. It also is one point on the employer’s “demand curve” for labor. That, together with supply, or the number of workers willing to do particular jobs at different compensation levels, determines market salary levels.
The theory goes on to say that in a perfectly competitive free market, every worker will earn this “marginal revenue product” of their labor. If some people earn more than others, it is because what they produce is of greater value to society.
Take that theory and bounce it against the reality that a local TV news anchor earns over $500,000 while his divorced wife might earn $37,000 as a schoolteacher. Or that the new president of the University of Minnesota will earn $610,000, some 75 percent higher than his previous job and a third higher than his predecessor got after eight years on the job. Or consider the $90,000 in annual disability payments 8th District congressman Chip Cravaack gets from his former employer because sleep apnea keeps him from working as a pilot.
Do all of these highly compensated people really make that large a contribution to society? Is the economic theory simply bunk? Or do economists have other explanations?
Our first answer would be that in the real world, the necessary conditions for perfect competition – many buyers, many sellers, no monopoly power, a uniform product, good information, low transaction costs, no “barriers to entry,” etc. – seldom hold true. When they don’t, compensation and value produced for society are not necessarily equal.
For example, while local TV news broadcasting is competitive, individual stations have considerable market power. The need for a federal license constitutes a “barrier to entry” into the business. So stations earn monopoly profits that make it possible to pay large salaries for key talent. Popular reporters and anchors thus capture some of the benefit of their employers’ monopoly power.
The same long was true for airline pilots. When the Civil Aeronautics Board regulated airline routes and fares, existing carriers earned monopoly profits because such regulation protected them from competition. They could pass additional costs along to passengers and thus were complacent in granting high salary and benefit packages to unionized pilots. These included disability compensation plans that were extremely generous compared with most other occupations.
This began to fall apart in 1978 when the Carter administration deregulated airlines. Long-established airlines were exposed to competition from new lower-cost carriers. They had to cut costs or go broke. Equipment and fuel costs could not vary much, so the adjustment had to come in personnel costs.
The process has been going on for 30 years, with many older companies now out of business. The survivors had to cut pay. This was easier with lower-skilled workers but progressively harder for skilled machinists and especially with pilots. Some of the surviving companies have two-tier salary scales with older pilots grandfathered in but new hires earning considerably less. Congressman Cravaak’s disability payments are one vestige of a nearly extinct monopoly based in government regulation, but young pilots cannot count on the same sort of largesse.
What about university presidents’ salaries? As with TV stations, large universities are limited in number. Nearly all are nonprofit and some are government, so they lack the market-driven cost-containment incentives of the television business. Big 10 education certainly isn’t perfect competition.
However, all this raises the question of why salaries for presidents of big-name universities have outpaced those of faculty, just as pay for local television personalities has risen so much faster than other professions. The same is true for sports stars. The ratio of the pay of the biggest stars, compared with the average for other pros in the same sport, has risen sharply in risen decades. Ditto for corporate CEOs, at least in the United States.
This question, “the economics of superstars,” is fascinating to economists and has spawned a whole subfield of research within labor economics. It contributes to the increasingly unequal distribution of income in U.S. society as we move to what some economists term a “winner-take-all economy.” But these are subjects for other columns.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.