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devil duck

armchair economics

I started thinking about Say's Law, which is usually stated as "Production creates its own demand."  IIUC, the idea is that if you produce something, you now have an asset that you can trade with somebody else for his/her assets, thus creating a demand for those other assets exactly equal to the asset you produced.  The more production, the more assets, so the more demand.

One possible problem with this is that the desire for something isn't in the same place as the assets to pay for it.  Suppose you produce something that lots of people want, but most of the people who want it are producing very little -- say, they're unemployed or underemployed -- so they don't have a lot of assets to trade for what you produce.  Perhaps they can't even afford to buy it at your cost, which is the lowest price at which you're likely to want to sell it.  So you stop producing it.  Rather than production creating its own demand, we have a sort of contrapositive: the lack of demand creates a lack of production.  But presumably the reason you were producing that thing is that you're GOOD at producing it, so by switching your production to something else, you've made the whole economy less efficient.

A related problem: suppose you produce something, but you DON'T have the asset you just produced -- your employer does. Your employer now has a bunch of buying power, but isn't interested in buying the same things you want, so there is effectively no demand for the things you want, which means they won't be produced.  Indeed, your employer may be not interested in buying anything at all, which means all the assets you produced are just sitting in your employer's bank account, not creating any demand at all.

How can this happen?  Ask anybody who works at McDonald's or Wal-Mart.

What is a worker worth?

One answer says "you get paid what you're worth -- indeed, what you're worth is DEFINED (in a market economy) by what you can get through negotiation."
Another answer says "you're worth what you produce," i.e. the value added by your labor.

These answers don't necessarily match one another very closely.  In fact, if you work for a for-profit company, what workers get paid must be LESS than the value-added that they produce, or there would be nothing left to show as profit.  (For simplicity, I'll assume that all of a company's value-added -- its revenues minus its non-labor spending -- is created through labor, not through (say) buying something and holding onto it until it appreciates and can be sold for a profit.)  But that's not true for all workers, only for the AVERAGE.  Specifically, the total wages of all the workers in the company must be less than the total value-added of all the workers in the company, in order for there to be a profit.  How much less depends on the worker's bargaining position: if the worker is hard to replace and knows it, (s)he can negotiate a wage that's pretty close to his/her value-added, while a worker who's easy to replace is in a weaker bargaining position and will probably get paid considerably less than his/her value-added.

There are even circumstances in which a worker can negotiate a wage that's HIGHER than his/her value-added.  This clearly isn't in the best interest of the company, but if the worker in question happens to be in upper management, able to effectively set his/her own salary, it's in the worker's best interest to set that salary as high as possible, regardless of the best interest of the company.  Naturally, the manager in question doesn't want the company to go bankrupt, so in order to raise his/her own salary, (s)he needs to keep the AVERAGE salary below the AVERAGE value-added by lowering everybody else's salary.  But you can't do that if your workers are in a strong negotiating position, so for your own best interest (if not necessarily the company's), you need to put them in a weak negotiating position: bust the union and keep overall unemployment rates high.

I was involved with the Co-ops And Enterprises Board at my graduate school (UC San Diego).  UCSD had a thriving bunch of student-run, on-campus businesses, many of which were organized as egalitarian co-ops.  At one point there was a discussion of how to set salaries for co-op workers, and the University administrators on the board said "we can't let people set their own salaries: there's an obvious conflict of interest, people will set them too high and the co-op will go bankrupt."  The Co-op people replied "There's no problem with people setting their own salaries, because they know that if everybody in the co-op gets paid too much, the co-op will go bankrupt.  The conflict of interest arises when one person can set not only his/her own salary but other people's as well, as happens at the University bookstore: the manager can set his own salary high and the check-out clerks' low.  In a co-op, no one person's salary will be much higher than everybody else's, so this isn't a problem for a co-op."  The University administrators somehow didn't see the logic in this.

Anyway, the problem arises, predictably, whenever the people making salary decisions for a whole company are a small subset of the paid employees of that company.  If the decisions are made by a large subset, those people's salaries can't be too much higher than anybody else's, while if the decisions are made by people who aren't paid employees at all, there's no conflict of interest and the decision-makers can act in the best interest of the company.  Yet there IS a skill to management, managers DO provide a useful service to a company, so they deserve to get paid for that service.  The question is how to pay fairly for their management services without allowing their management position in the company to enable them to set their own salaries higher than their value-added.  You could try some sort of "peer" salary-setting -- I don't set my own salary, but I get to participate in setting the salaries of all the other managers at my rank -- but as long as the set of managers is a fairly small subset of all the workers, this still encourages them as a group to set their own salaries irrationally high and everybody else's low.

It's late: I'd better get to bed.


Interesting thoughts. I like the distinction drawn between the "valued-by-value-add" view and the "valued-as-paid" view...on first glance these 'ought' to be the same, but clearly they aren't.

How do you feel the "taboo" nature of salary feeds into this? Many companies prohibit employees from discussing their salary; others keep the salaries of certain employees (usually mid-to-upper management) a closely-guarded secret, or (if public) hide them behind smoke screens of compensation packages; does this affect the moral decisions behind one's salary?
Good question. Obviously, if management doesn't want a particular kind of information to get around, it's because they believe its release would weaken their negotiating position. Conversely, if a labor union negotiates a flat, widely-known pay scale for each job title, it's because they believe that strengthens their negotiating position.

Of course, there's no law of nature saying that management must make decisions in their own interest against the interest of the company; indeed, I would bet that the great majority of management decisions really are in the best interest of the company (and not just "the managers convinced themselves it was in the best interest of the company"). So the fact that management doesn't want salary information getting around doesn't necessarily mean salary information should be spread around. But if everybody knew how much everybody made, one suspects that social pressure would bring about (a) less variation in pay within a job title, and (b) less-dramatic differences in pay between lower and higher job titles.

My strongly-unionized until-two-weeks-ago employer releases (internally) an annual list of average salaries by department and rank, but not individual. Of course, in some departments there's only one person at a given rank, so that information is effectively individualized. The current union contract doesn't say everybody at a given rank has to get paid the same -- that's decided in negotiation on initial hire -- but it does say everybody has to get the same annual adjustment and everybody has to get the same increase on promotion. There are a few other ways to get a raise, e.g. a competing offer.

My non-unionized new employer, I think, releases (internally, in real time) every employee's job title and integer "level", but there's no standard pay scale per job title or level; that's decided in negotiation between individual worker and massive company.
It seems to me that fundamentally, our society is struggling with the question of just what the value added of management (the practice) is.

If I learned anything from the SCA, it's that (1) the quality of management (administration, coordination, leadership, stewardship, etc.) plays an enormous role in the quality of the result of any enterprise, and (2) most people are oblivious to this fact, having no idea what managers do or what difference it makes, because they've never been in charge of team effort before. And I say this as someone in the "eat the rich" camp, who in no way intends to make excuses for extortionate executive compensation.

I guess where I'm going with this is that we as a society have no sense of how to even go about deciding what level of compensation is "fair" for an executive. We have no yardstick against which to measure. We have some nebulous sense "if an executive makes more than N * the lowest paid worker, that's an outrage", but nothing really more specific. Does lowering it to N-5 make it okay? Or should it be measured as a function of some other variable? Or what?

Edited at 2014-06-19 05:52 pm (UTC)
Right. It's fairly easy to judge the "value-added" of an assembly-line worker, but much harder for somebody whose main job is to manage other people. Indeed, it could be argued that addition isn't even the right model so much as multiplication.

However, if "value-added" is meaningful at all, I take it as axiomatic that it's never in the best interest of the company to pay you more than you add to the company. So if we could conduct a salary negotiation between the manager and "the company" as a whole, without the manager's own thumb on the scale, that would give us a (probably reasonably close) lower bound and therefore a reasonably "fair" salary.
However, if "value-added" is meaningful at all, I take it as axiomatic that it's never in the best interest of the company to pay you more than you add to the company.

Yes. (Marx says this, too, I think.)

So if we could conduct a salary negotiation between the manager and "the company" as a whole, without the manager's own thumb on the scale, that would give us a (probably reasonably close) lower bound and therefore a reasonably "fair" salary.

Well, I certainly think it's a good idea, but "fair" is in some important sense a social construct, and I'm not sure that would result in one of those.
Right; I wouldn't claim that such a procedure would meet everyone's definition of "fair". But let's imagine how it could work.

The stakeholders in the long-term health of the company are mostly either employees, capital investors (shareholders), or creditors. One simple approach would be to tell each of those people about the prospective upper manager, ask each person for a salary figure, take the median of those salaries, and offer it to the prospective upper manager. Most likely the first such offer would be too low to persuade any competent manager to accept the job, and the company would have to muddle through without an upper manager for a while. If most of the stakeholders are convinced that the company would benefit from having an upper manager, they can try again, offering more this time. Eventually either they'll reach a level that persuades a manager to take the job, or they'll conclude that the benefits to the company of filling that position are less than what it would cost to fill it, so they won't.

Why is this "fair"? Because every stakeholder has had a real input into the process. In practice, an upper manager will have to be paid more than the average worker -- it's a specialized skill, after all -- but probably not 300 times more.

Of course, it seems wrong to have the owner of one share of stock count the same as somebody who's been working at the company for twenty years. So weight people's "votes" by how much stake they hold in the company. For shareholders, that's the amount of stock they own. For salaried employees, that's equivalent to the amount of stock whose typical dividends, if they owned it, would produce their current salary. (For example, at a P/E ratio of 15, that would be the amount of stock costing 15 times your annual salary.) For creditors, it's an amount of stock that would cost what the company currently owes them.

Of course, if one person controls 51% of the stock (under this broad definition of "stock"), that person controls the median... but the way I've defined employee stakes above, that's difficult to do. Even if the CEO's salary is currently 300 times what the median employee earns, it only takes 300 median-pay employees -- a tiny fraction of the myriads of employees such a company typically has -- to balance the CEO's stake. This approach would probably lead to higher manager pay than the previous approach, but still not 300 times the median.

The neat thing about the "median" approach is that if a current manager says the upper-manager salary should be ninety-leven zillion dollars, it makes no difference: a figure $5 above the median counts just the same as a figure several orders of magnitude above the median. And there's very little incentive for me to "bid" less or more than I honestly think the manager should be paid, because unless I happen to be very close to the median bid (in a neighborhood probably densely populated with other bids), it doesn't matter.

In fact, this approach could be applied not only to individual upper-manager pay scales, but also to pay scales for broad categories of workers. Members of that category have an incentive to "vote" their own salary up, but ALL the stakeholders have an incentive to keep the salaries to something the company can afford.

Edited at 2014-06-21 04:59 am (UTC)

Another thing that can go wrong

Suppose you produce something, but it sits on your shelves waiting for customers. Yes, you've "supplied" something, but it hasn't turned into cash so you can buy other people's products, so it has NOT "created its own demand"; it has instead created inventory.

In a free market, weak demand and rising inventories should mean you drop your prices until people are willing to buy -- but if that brings it below your production cost, you probably won't go that far. Instead, you'll stop making stuff you can't sell. If you can switch production to something else, great; if not, you'll just lay off workers, further reducing the amount they can spend, and the whole economy shrinks.