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So all right, maybe it’s true that when it comes to low-income workers’ wages, the price mechanism and the basic forces of supply and demand are the most important factors we have to take into consideration. But what about the other side of the income coin – i.e. workers who earn extremely high salaries? How do these market mechanisms make it possible for some people to earn millions of dollars despite working the same number of hours as others who only earn a fraction of that? And isn’t this absurdly unfair?

Well, to answer the latter question first: Yes, of course it’s unfair, for all the reasons we’ve already covered. (And I’ll have even more to say about the necessity of alleviating the adverse effects of this unfairness in future posts, in addition to what I already said about it in my last post.) But as we’ve also already established, wages aren’t a matter of fairness; they’re an inducement to provide a service. They’re a price just like any other price. And so with this in mind, we can begin to understand the answer to the first question, of how it’s possible that the normal functioning of the market could result in some people being paid millions of dollars in the first place. Long story short: If a particular person is one of the only people in their field who can produce millions of dollars of value for their employer, and multiple employers want to win that value for themselves, they’ll bid up that person’s pay to a multi-million dollar level, just as a natural result of wanting to maximize their own productivity (and therefore their earnings) as firms. This is easy enough to understand when we look at professional entertainers like musicians and athletes – i.e. individuals who even we lay people can tell are head-and-shoulders above the rest of their field. We all understand why every NBA team would be willing to pay millions of dollars to sign LeBron James; it’s because they know he’d bring in millions of dollars more for them than a less talented player would. But as Sowell writes, this basic principle also generalizes to every other field – including those that we lay people can’t always appreciate quite as easily, like the much-vilified area of corporate leadership:

The high pay of corporate executives in general, and of chief executive officers in particular, has attracted much popular, media, and political attention—much more so than the similar or higher pay of professional athletes, movie stars, media celebrities, and others in very high income brackets. The median pay of chief executive officers of corporations important enough to be listed in the Standard and Poor’s index in 2006 was $8.3 million a year. While that is obviously many times more than most people make, it is exceeded by the income of women’s golf star Michelle Wie ($12 million), tennis star Maria Sharapova ($26 million), baseball star Alex Rodriguez ($34 million), basketball star Kobe Bryant ($39 million) and golfing great Tiger Woods ($115 million). Even the highest paid corporate CEO, earning $71.7 million a year, made less than a third of what Oprah Winfrey makes.

Yet it is rare—almost unheard of—to hear criticisms of the incomes of sports, movie, or media stars, much less hear heated denunciations of them for “greed.” While “greed” is one of the most popular—and most fallacious—explanations of the very high salaries of corporate executives, when your salary depends on what other people are willing to pay you, you can be the greediest person on earth and that will not raise your pay in the slightest. Any serious explanation of corporate executives’ salaries must be based on the reasons for those salaries being offered, not the reasons why the recipients desire them. Anybody can desire anything but that will not cause others to meet those desires. Why then do corporations go so high in their bidding for top executive talent? Supply and demand is probably the quickest short answer—and any fuller answer would probably require the kind of highly specific knowledge and experience of those corporate officials who make the decisions as to whom to hire and how much pay to offer. Given the billions of dollars at stake in corporate decisions, $8.3 million a year can be a bargain for someone who can reduce mistakes by 10 percent and perhaps save the corporation $100 million.

Some have argued that corporate boards of directors have been overly generous with the stockholders’ money and that this explains the high pay of corporate CEOs. To substantiate this as a general explanation would require more than a few specific examples. This theory could be tested as a general explanation by comparing the pay of CEOs in corporations owned by a large number of stockholders, most of whom are in no position to keep abreast of—much less evaluate—decisions made within these corporations, versus the pay of CEOs of corporations owned and controlled by a few huge financial institutions with both expertise and experience, and spending their own money.

It is precisely these latter corporations which offer the highest pay of all for chief executive officers. These giant financial institutions do not have to justify their decisions to public opinion but can base these decisions on far greater specific knowledge and professional experience than that of the public, the media, or politicians. They are the least likely to pay more than they have to—or to be penny-wise and pound-foolish when choosing someone to run a business where billions of dollars of the institutional investors’ own money are at stake. While various activists have urged a larger voice for stockholders in determining the pay of CEOs in publicly held corporations, significantly the mutual funds that invest in such corporations have opposed this, just as major financial institutions that invest in privately held corporations are less concerned with corporate executives’ pay than with getting executives who can safeguard their investments and make them profitable.

Although many outsiders have expressed incredulity and non-comprehension at the vast sums of money paid to various people in the corporate world, there is no reason why those people should be expected to comprehend why A pays B any given sum of money for services rendered. Those services are not rendered to third party observers, most of whom have neither the expertise nor the specific experience required to put a value on such services. Still less is there any reason why they should have a veto over the decisions of those who do have the expertise and experience to assess the value of the services rendered. For example, the director of the company that publishes the Washington Post assessed the recommendations of one member of his board of directors this way: “Mr. Buffet’s recommendations to management have been worth—no question—billions.”

It is very doubtful whether Mr. Buffet’s compensation from the Washington Post Company alone runs into billions of dollars but it may well run into enough millions to cause third party onlookers to exclaim their incredulity and perhaps moral outrage. The source of moral outrage over corporate compensation is by no means obvious. If it is based on a belief that individuals are overpaid for their contribution to the corporation, then there would be even more outrage toward people who receive hundreds of millions of dollars for doing nothing at all, when they simply inherit fortunes. Yet inheritors of fortunes are seldom resented, much less denounced, the way corporate CEOs are. Three heirs to the Rockefeller fortune, for example, have been elected as popular governors of three states.

[The thing that seems] especially to anger critics of high corporate executive salaries [is] the belief that their high compensation comes at the expense of consumers, stockholders, and/or employees. […] But, like anybody who is hired anywhere, whether in a high or low position, a corporate CEO is hired precisely because the benefits that the CEO is expected to confer on the employer exceed what the employer offers to pay. If, for example, an $8.3 million a year CEO saves the corporation $100 million as expected, then the stockholders have lost nothing and are in fact better off by more than $90 million. Neither have the consumers nor the employees lost anything. Like most economic transactions, the hiring of a corporate CEO is not a zero-sum transaction. It is intended to make both parties better off.

It would be immediately obvious why the zero-sum view is wrong if someone suggested that money paid to George C. Scott for playing the title role in the movie Patton was a loss to stockholders, moviegoers, or to lower-level employees who performed routine tasks during the making of the movie. Only if we believe that Patton would have made just as much money without George C. Scott can his pay be regarded as a deduction from the money otherwise available to stockholders, moviegoers, and other people employed making the movie. Much has been made of the fact that corporate executives make many times the pay of ordinary workers under them—the number varying according to who is making the claim—but no one would bother to figure out how many times larger George C. Scott’s pay was than that of movie extras or people who handled lights or carried film during the production of Patton.

A quick side note, by the way: If you’re like me, you might be somewhat skeptical that a company’s choice of CEO can really have such a significant effect that it can make millions of dollars’ worth of difference. But Sowell points to some (kind of heartbreaking) evidence suggesting that it really does matter whether a CEO is at the top of their game or not:

The importance of the personal factor in the performance of corporate management was suggested […] by a study of chief executive officers in Denmark. A death in the family of a Danish CEO led, on average, to a 9 percent decline in the profitability of the corporation. If it was the death of a spouse, the decline was 15 percent and, if it was a child who died, 21 percent. According to the Wall Street Journal, “The drop was sharper when the child was under 18, and greater still if it was the death of an only child.” Although corporations are often spoken of as impersonal institutions operating in an impersonal market, both the market and the corporations reflect the personal priorities and performances of people.

Of course, not every company pays its CEO in proportion to the value they’re creating. Sometimes, companies can – and do – overpay their executives for more banal reasons, like wanting to make themselves appear stronger and more self-confident by paying their executives more than the industry average, or in the worst cases, simply failing to implement adequate governance mechanisms for preventing conflicts of interest between their executives, their boards of directors, and their shareholders. (This seems to be a particularly unique problem in the US, occurring quite a bit more often here than in other rich countries.) But that’s yet another topic for a future discussion; for now, we’ll just note that although these failures of corporate governance do exist, the pressures of the market have a way of weeding out such companies if their internal issues become severe enough to undermine their ability to function efficiently – with firms like Enron being the biggest examples that come to mind. In other words, when employers overpay for executives that aren’t creating positive value for them, it tends to be a mistake that punishes itself. A firm that’s actually operating efficiently will only offer a high salary to an executive who’s creating even more value than what they’re paid.

Returning to the main thread of his discussion, Sowell adds some context to his key line from before about pay being an incentive rather than a reward:

Third parties who take on the task of deciding who “really” deserves how much income often confuse merit with productivity, quite aside from the question whether they have the competence to judge either. In no society of human beings has everyone had the same probabilities of achieving the same level of productivity. People born into families with every advantage of wealth, education, and social position may be able to achieve a high level of productivity without any great struggle that would indicate individual merit. Conversely, people who have had to struggle to overcome many disadvantages, in order to achieve even a modest level of productivity, may show great individual merit. But an economy is not a moral seminar authorized to hand out badges of merit to deserving people. An economy is a mechanism for generating the material wealth on which the standard of living of millions of people depend.

Pay is not a retrospective reward for merit but a prospective incentive for contributing to production. Given the enormous range of things produced and the complex processes by which they are produced, it is virtually inconceivable that any given individual could be capable of assessing the relative value of the contributions of different people in different industries or sectors of the economy. Few even claim to be able to do that. Instead, they express their bafflement and repugnance at the wide range of income or wealth disparities they see and—implicitly or explicitly—their incredulity that individuals could differ so widely in what they deserve. This approach has a long pedigree. George Bernard Shaw, for example, said:

A division in which one woman gets a shilling and another three thousand shillings for an hour of work has no moral sense in it: it is just something that happens, and that ought not to happen. A child with an interesting face and pretty ways, and some talent for acting, may, by working for the films, earn a hundred times as much as its mother can earn by drudging at an ordinary trade.

Here are encapsulated the crucial elements in most critiques of “income distribution” to this day. First, there is the implicit assumption that wealth is collective and hence must be divided up in order to be dispensed, followed by the assumption that this division currently has no principle involved but “just happens,” and finally the implicit assumption that the effort put forth by the recipient of income is a valid yardstick for gauging the value of what was produced and the appropriateness of the reward. In reality, most income is not distributed, so the fashionable metaphor of “income distribution” is misleading. Most income is earned by the production of goods and services, and how much that production is “really” worth is a question that need not be left for third parties to determine, since those who directly receive the benefits of that production know better than anyone else how much that production is worth to them—and have the most incentives to seek alternative ways of getting that production as inexpensively as possible.

In short, a collective decision for society as a whole is as unnecessary as it is impossible, not to mention presumptuous. It is not a question of rewarding input efforts or merits, but of securing output at values determined by those who use that output, rather than by third party onlookers. If the pleasure gained by watching a child movie star is valued more highly by millions of moviegoers than the benefits received by a much smaller number of people who benefit from buying the product of the drudgery of that child’s mother, by what right is George Bernard Shaw or anyone else authorized to veto all these people’s choices of what to do with their own money?

Although one person’s income maybe a hundred or a thousand times greater than another’s, it is of course very doubtful that one person is a hundred or a thousand times more intelligent or works a hundred or a thousand times as hard. But, again, input is not the measure of value. Results are.

The absence of Tiger Woods from various golf tournaments in the United States for several months, due to a knee operation in 2008, led to declines in television audiences ranging from 36 percent for the World Golf Championship to 55 percent for the PGA Championship.

In a multibillion dollar corporation, one person’s business decisions can easily make a difference of millions—or even billions—of dollars, compared to someone else’s decisions. Those who see paying such a person $10 million or $20 million a year as coming at the expense of consumers or stockholders have implicitly accepted the zero-sum view of economics. If the value of the services rendered exceeds the pay, then both consumers and stockholders are better off, not worse off, whether the person hired is a corporate CEO or a production line employee.

Would anyone say that the pay of an airline pilot comes at the expense of passengers or of the airline’s stockholders, when both are better off as a result of the services rendered? Would anyone even imagine that one pilot is as good as another when it comes to flying a commercial jet airliner with hundreds of people on board, so that getting some crop-duster pilot at lower pay to fly the jet would make the stockholders and the passengers better off? Yet that is the kind of reasoning, or lack of reasoning, that is often applied when discussing the pay of corporate CEOs—and virtually no one else in any other field, including professional athletes or entertainers who earn similar or higher incomes. Perhaps the most fallacious assumption of all is that third parties with neither experience nor expertise can make better decisions, on the basis of their emotional reactions, than the decisions of those who have both experience and expertise, as well as a stake in the results.

Despite the popularity of the phrase “income distribution,” most income is earned—not distributed. Even millionaires seldom simply inherited their fortunes. Only a fraction of the income in American society is actually distributed, in such forms as Social Security checks or payments to welfare recipients, for example. Most income is “distributed” only in the figurative statistical sense that the incomes of different people are in varying amounts that can be displayed in a curve on a graph, as in the previous discussion of middle class incomes. But much of the rhetoric surrounding variations in income proceeds as if “society” is collectively deciding how much to hand out to different individuals. From there it is a small step to arguing that, since “society” distributes income with given results today that many do not understand or like, there should be a simple change to distributing income in a different pattern that would be more desirable.

In reality, this would by no means be either a simple or innocuous change. On the contrary, it would mean going from an economic system in which most people are paid by those particular individuals who benefit from their goods and services—at rates of compensation determined by supply and demand involving those consumers, employers, and others who assess the benefits received by themselves—to an economy in which incomes are in fact distributed by “society,” represented by surrogate, third-party decision-makers who determine what everyone “deserves.” Those who think that such a profound change would produce better economic or social results can make the case for such a change. But making such a case explicitly is very different from gliding into a fundamentally different world through verbal sleight of hand about “income distribution.”

Let’s say, just for the sake of argument, that we did conclude that a multi-million-dollar salary was more than anyone deserved, and so we decided as a society to set a “maximum wage” of $1M per year. If we did this, then someone who was capable of creating either $10M of value at Company A or $2M of value at Company B, but was receiving an offer from both companies of just $1M (since that was the maximum allowable amount), would have no financial reason to prefer one over the other – and so they might very well decide to go to work for Company B, which would mean that the extra $8M of value they might have produced at Company A would be lost. It wouldn’t just be a loss for Company A, either; after all, if their hiring would have generated an extra $8M of revenue for the company, that means it would have provided customers with something that they’d valued at a level even higher than that (since, after all, the customers voluntarily paid that $8M in exchange for the company’s products) – so by preventing that $8M worth of transactions from ever taking place, the maximum wage law would be taking away that consumer surplus from those customers. Allowing employers to offer whatever salaries they wanted to, on the other hand, would naturally direct the most productive workers to the employers for whom they could produce the most value – and this would mean better results for the workers, the employers, and the customers alike.

Of course, that doesn’t mean that we wouldn’t be able to do anything about whatever disparities in wealth might arise as a result of this approach; we can and should want to make sure our society isn’t split into a dichotomy of billionaires and paupers. All it means is that setting price ceilings on people’s labor wouldn’t necessarily be the best method of accomplishing this goal. I’ve already laid out the basic economic argument for why, in the case of lower-income workers, it’s better not to mess with their wages by trying to control them directly via government mandate, but instead to take a default approach of just letting the price mechanism do its thing, and then if the results seem unacceptably unfair or unjust, only coming in after the fact with correctives like taxation and redistribution. And it seems to me that the same is true for high-income workers. Whatever we might personally think of their merits as individuals, it’s better to let the market determine the price of their labor rather than trying to set it at a particular pre-determined level – and then, if we don’t think the resulting allocation of income is good for society, we can use the mechanisms of taxation and redistribution after the fact.

Continued on next page →