Income Inequality

Thomas Sowell is not disturbed by the fact that people don’t understand why CEO’s make so much money.

Ninety-nine percent of all the things that happen in this world “make no sense” to any given individual. Do you understand how your automobile’s transmission works? Could you repair it if something went wrong?

Do you understand how aspirin stops headaches? How to make yogurt?

Years ago, a famous essay pointed out that nobody knows how to make a simple lead pencil. That is, there is no single individual anywhere who knows how to grow the wood, mine the graphite, produce the rubber, and manufacture the paint.

Complex economic processes cause all these things to be done and coordinated by a wide variety of people, just in order to produce something as simple as a lead pencil. Multiply that by a hundred or a thousand when it comes to the complexity of producing a car or a computer.

If you cannot understand something as simple as making a lead pencil, why should you be surprised that you don’t understand why someone is making a lot more money than somebody else?

Dale Franks has an amusing example:

For instance, let’s say we have a society of 1000 people, each of whom has $100. One of the people, who is a talented musician, decides to hold a concert, and charge $10 per ticket. All of the other members of our little society decide to attend, and by the time the concert’s over, our musician now has $10,090, while the other 999 people have only $90. Our musician now has 112 times the wealth of anyone else in the society.

Well, this hardly seems fair does it?

James Glassman (via Steve Bainbridge) justifies ginormous CEO salaries by making a comparison:

These talented generalists are scarce and can have a huge effect on profits. Sure, they command high pay. Too high? The Yankees’ Alex Rodriguez earned $29 million from June 2005 to this summer. Jeff Immelt of General Electric makes less than Dr. Phil does. If a good CEO can boost profits by $200 million, he’s easily worth $10 million, or more.

Indeed, it’s amusing that people get much so outraged by high executive salaries but don’t bat an eye at an actor making $20 million to make a movie. Then again, Jeff Immelt doesn’t have his own TV show, so how smart can he really be?

FILED UNDER: Economics and Business, , ,
James Joyner
About James Joyner
James Joyner is Professor and Department Head of Security Studies at Marine Corps University's Command and Staff College and a nonresident senior fellow at the Scowcroft Center for Strategy and Security at the Atlantic Council. He's a former Army officer and Desert Storm vet. Views expressed here are his own. Follow James on Twitter @DrJJoyner.

Comments

  1. Charlie says:

    I have no problem with an executive making whatever the Board of directors is willing to pay him. I do have a problem with interlocking, almost incestuous directorships that pretty much guarantee large pay or golden parachutes regardless of performance.

    But then, we also see that in various state and local political settings – – –

  2. Rick DeMent says:

    James,

    Sowell and other “jackpot capitalism” cheerleaders make a fundamental mistake in their analysis of this phenomenon. It’s not that people don’t understand it, it’s precisely that people do understand it cannot conceive of any scenario where these bonuses have any connection whatsoever to performance of the duties of the CEO. Look if you want to be one of life’s suckers and go along with this fine, but don’t expect anyone with a brain to believe that a CEO can’t be found who could do the same job without being paid these sums.

    There are many talented executives who could do the same job for a fraction of that kind of money. The problem is what Charlie pointed out, the rigged and gamed nature of CEO selection and the compensation committees and the complete lack of oversight by shareholders who are mostly large institutional investors that simply don’t care about the issue. I mean if CEO’s were actually punished for bad performance then I could understand but they aren’t.

    As for actors at least they have some claim on the money generated at the box office. It is their name that generates the cash to some extent, and their salary goes down with their popularity. And while CEO’s have a large degree of influence over the direction of a corporation they never seem to get punished in any significant way for failure. Indeed even when they are pushed out the boards fall all over themselves to see who can design the most lavish “exit” packages.

    While I agree that it is not the fault of the CEO for accepting the money, the issue is why are compensation committees set up in a way that guarantees that these kinds of shenanigans continue? Cleary it’s because those at the top want it that way. There is no way to justify this and it has nothing to do with “envy” or “class warfare”.

  3. James Joyner says:

    Rick,

    Most people have little understanding of economics. If you can’t understand why a professional basketball player earns more than a high school teacher, you certainly can’t understand CEO pay. Indeed, most of us really don’t understand what CEOs do.

    As Glassman notes, there is a lot of competition for executives, with most firms luring away someone who is successful elsewhere rather than promoting from within. And even an incentive-laded deal means big, big bucks when you’re taking on a multi-billion dollar enterprise.

  4. Anon says:

    I think most people can grasp the concept that if a CEO can consistently boost his company’s profits by $200 million, compared to some other person at the helm, he should be paid quite a bit of money.

    I think the real reason people aren’t as outraged at the high salaries of actors and athletes is that they can clearly see the difference between the ones around them and the stars. On the other hand, the perception of CEOs is that they make millions for coin-flip-type decisions that seem to lose money as often as they make money. People then feel that the CEO is not doing anything that they couldn’t do.

  5. DC Loser says:

    How much are the CEOs of GM and Ford getting paid for running their companies into the ground? The companies would have been better off if they had NO CEOs during the past decade, given the disastrous results.

  6. LJD says:

    What many miss in these simplistic comparisons is the difference between public and private. Voters and stockholders have some control over how an organization utilizes ‘their money’.

    My only argument against movie actors and sports stars is the COST to attend a game or movie. But, that’s supply and demand…

    But if I start manufacturing proprietary widgets that revolutionizes whtever they do, who has the right to tell me a couple of kajillion dollars is too much for me to have?

  7. lily says:

    Upon what data have you based the assumption that ridiculously high CEO salaries are disapproved of by large numbers of unnamed people who also approve of ridiculously inflated actor salaries?

    The problem with the inflated CEO salaries is two fold: as a poster noted above, mostly it is not performance based, and the second issue is that the discrepancy between those that actually do the work that makes the company profitable and those that get the unmerited multimillion dollar bonuses is too great to be healthy.

    You imply that there is something wrong with the values of people who are willing to overpay actors but not CEO’s. I think there is something wrong with the values of people who are willing to underpay the people who do the work while grotesquely overpaying, with no accountability for performance, the CEO’s.

  8. Dave Schuler says:

    A number of the previous commenters have touched on some of the various problems with excessive CEO compensation but I’ll try and collect them.

    First, I’ve known perhaps a half dozen Fortune 500 CEO’s over the years (by “known” I mean they knew me by my first name and we lunched together one-on-one; I’ve also been to one such’s home). They’re overpaid.

    Why do large company CEO’s make so much? Well, because they like money (most people do) and have the votes on the board of directors to swing it (friendly CEO’s of big companies on each others’ BOD’s, coincidentally, may have something to do with it). Stock-based compensation plans frequently mean that when the stock market goes up, regardless of why it goes up, CEO’s get a raise.

    A CEO whose company prospers gets a whopping raise; one whose company is failing is “helping the company weather troubling times” and gets a whopping raise. Consider airline execs, automobile company execs, and other companies who’ve been failing for a generation.

    I think that attempts to rationalize this are amusing. Sometimes the rich are rich because they’re rich.

  9. floyd says:

    Professional sports are simply not worth the price of admission because of the obscene salaries paid. Many of us understand that and refuse to participate as a result. Obscene CEO salaries rob investors of their fair share to an even greater degree than the CEO’s superstar talents warrant. Responsible balance is the purview of boards of directors who are too involved in cronyism to be objective or responsible.

  10. Steve Verdon says:

    DC Loser,

    William Clay Ford Jr. is paid $0 in salary and last year, exercised $2.11 million in stock options. He is the Chairman, Chief Operating Officer, Chairman of Environmental & Public Policy Committee, Chairman of Fin. Committee and Chairman of Exec. Operating Committee.

    The Chief Financial Officer, Exec. VP and Member of Exec. Operating Committee Donald Leclair was paid $916,000 and exercised $0 in stock options.

    As for GM, G. Richard Wagoner Jr. was paid $2.2 million and exercised $0 in stock options. He is the Chairman, Chief Exec. Officer. Robert A. Lutz, Vice Chairman of Global Product Devel. and Acting Chief Exec. Officer of GM Europe was paid $1.55 million and exercised $0 in stock options.

    If you are looking for the really big bucks try Richard D. Fairbank the founder, Chairman, CEO, and President for Capital One Financial who exercised $249.27 million is stock options. Of course, the company also had a profit margin of 22%.

  11. legion says:

    Wow. There’s so many things wrong with this discussion, I’m not sure where to start. I’ll try at the beginning – Sowell’s holier-than-thou attitude belies his utter economic quackery. Equating natural phenomena like aspirin or graphite to concrete human decisions like CEO salaries is an unprofessional and infantile attempt to throw sand in his readers’ eyes. If CEOs cannot justify their salaries to the people who pay them – the shareholders – then they do not deserve the money; if they can, then they do QED. Likewise, if Sowell can’t explain it to his readers, and instead writes an entire column sanctimoniously patting said readers on the head and saying “there there, stupid little children; don’t worry your pretty little heads”, then he deserves to be out on the streets.

    I thought at first that Dale’s example was facetious, but it appears not – unfortunately it’s also trite and straw-heavy… that musician doesn’t just collect the ticket money, sing a few bars, and hum the chorus all the way to the bank – even in that example, the ticket money gets paid back out to rent the arena, pay the backup band, pay for instruments, etc., etc., etc. Money is like energy, it neither appears nor disappears – it must come from somewhere, and it must also go somewhere.

    I do however agree with James (and James) – why do people get so worked up over CEO pay, but not athlete or Hollywood pay? I don’t own vast amounts of stock, so I recognize that my opinions about CEO pay only go so far, but I am more likely to go see a game or movie – or not, if the prices are too high…

  12. jpe says:

    Dale Franks has an amusing example:

    More accurately: Robert Nozick has an amusing example. Dale Franks borrowed it. (to be charitable).

  13. Steve Verdon says:

    Talk about economic nonsense,

    Money is like energy, it neither appears nor disappears – it must come from somewhere, and it must also go somewhere.

    Sorry, but money can and does “just appear”. The government creates it as we have a fiat money system. Creating too much money can lead to inflation. Decreasing the supply of money can lead to deflation.

    As for the example, it is intended to show that the the idea of income inequality isn’t always what we are lead to believe. In the example the people paying for the show get something that is worth at least the price of admission. As such, there is no inequality if you were to look at the welfare of the individuals. In practice we can’t do this, so income becomes a proxy and also a crude way to try and measure the “fairness” of the economic system.

    And finally Legion you are conflating what Sowell said with your own pile of straw. Sowell didn’t say that people don’t know understand the uses of graphite nor was he comparing graphite to human actions. He was comparing the lack of understanding of the human action of making a pencil to the human action of determining CEO pay.

    Finally, I think that Sowell is reponding to the rather insipid comment by Janet Yellen about income inequality and her discussion of the role of CEO pay. CEO’s make up a very small fraction of the population and hence even if they were all paid $500 million would likely have a very minimal effect on income inequality.

    Any discussion of income inequality that doesn’t factor in the issue of illegal and legal immigration is misleading and goofy as I’ve argued in the past.

  14. legion says:

    The government creates it as we have a fiat money system. Creating too much money can lead to inflation. Decreasing the supply of money can lead to deflation.

    But doesn’t even that money need to be guarranteed somehow by Treasury holdings? Or have we moved fully into the all-credit, no-capital phase of economic evolution? 🙂

    And as for the graphite example, I may have overreached, but statements like:

    If you cannot understand something as simple as making a lead pencil, why should you be surprised that you don’t understand why someone is making a lot more money than somebody else?

    Seem more than a little high-handed; the rest of the article does not alter that impression.

    Finally, I think that Sowell is reponding to the rather insipid comment by Janet Yellen about income inequality and her discussion of the role of CEO pay. CEO’s make up a very small fraction of the population and hence even if they were all paid $500 million would likely have a very minimal effect on income inequality.

    Any discussion of income inequality that doesn’t factor in the issue of illegal and legal immigration is misleading and goofy as I’ve argued in the past.

    While I don’t disagree that immigration is an important factor in such discussions, is its impact (both in immediate $$ figures and societal/consumer confidence impact) really that much more significant than executive compensation?

    Also, what is the Yellen comment? I don’t see it in the Sowell article.

  15. Steve Verdon says:

    But doesn’t even that money need to be guarranteed somehow by Treasury holdings?

    No. Basically, our money has value because we think it has value. That is we’ve designated it as a medium of exchange.

    Seem more than a little high-handed; the rest of the article does not alter that impression.

    Maybe, but I have no idea how they make pencils. I suppose I could go learn exactly they how it is done, but frankly I don’t care. What I do care about is that I have pencils.

    While I don’t disagree that immigration is an important factor in such discussions, is its impact (both in immediate $$ figures and societal/consumer confidence impact) really that much more significant than executive compensation?

    Which do you think is more important, adding 8 million people at the lower ends of the income scale or a few hundred at the upper end? Granted some CEOs do make really big bucks, but those guys are probably less than 100.

    As for not mentioning Yellen, one possible reason is that academics tend to be fairly mild when taking a colleague to task. Yellen is an important economist with some pretty substantial work with her name on it. She is also the head of the San Francisco Federal Reserve Bank.