Sorry for the long hiatus in blogging, I overcommitted between work and my MBA and something had to give.
But a rather good post on rents in the modern economy by Evan Soltas mentioned something that I had to talk about. It's a great post with some great ideas about how to build a research program within economics that would better define and detect rent seeking. However, it also exposed gave full display to some of the frustrations I have with the pedestal given to economic thinking when it is so limited in its methods.
Specifically he mentions "Is it really possible that, as Bloomberg put it, Larry Ellison is "still
a bargain" to Oracle at $100 million a year?" and later mentions "To Bivens and Mishel, executives would still do what they do even if they were
paid less -- Larry Ellison is not about to sail off in his America's Cup yacht
-- which means that executives are, in fact, being paid above their opportunity
cost. (The logic here is, if their pay falls below opportunity cost, they would
go do that other, next-best project which determines the opportunity cost.)"
The problem is that a fairly big chunk of this compensation problem is commonly and openly talked about in businesses, limiting your methodology as strictly as economists do cuts them off from picking some really low hanging fruit to resolve this problem.
Firms pay top management outrageous salaries because it is a way to reduce total compensation costs. You pay everyone else in the firm far less than they are worth and motivate them by getting them to struggle to gain that golden ticket that will lead them to the top. It reduces total compensation, motivates employees, and shifts consumer surplus from consumers and employees to shareholders and top executives.* Its no mystery, many of my management professors have mentioned this in passing, its widely accepted by both the left leaning members of the profession and the staunch right wing members. This is a natural, and probably inevitable, byproduct of shareholder capitalism.
The social costs of this are, in my opinion, terrible. Many people are unwilling to join the rat race, they want to be compensated fairly now not compete for decades in the hope of a reward that may or may not be rewarded on merit. These people never choose to compete for high power careers, sharply reducing the talent available to business, of course businesses never observe this since these people are not on their radar. Furthermore, there are not enough top positions to go around, this results in up or out promotion systems in many firms, practices such as forced rankings, and in some firms, mandatory retirement to keep the system going; further limiting the matching of available talent to open positions. Other problems are associated with the demands put on lower ranking employees, they have signed up for a major gamble and this drives reckless, and sometimes unethical, behavior, which harms their health, leads to psychological and physical stress associated with poor quality decision making, and drives many talented people to self select out rather than continue in high powered careers. The remnant which eventually gain leadership positions tend to be highly narcissistic (since they don't realize early on how low their odds of making it to the top are), highly motivated by money (since why give up so much of their life to get where they are), and prone to reinforce these norms because they take rightful pride in having made it to the top in such a cutthroat environment after having sacrificed so much.**
This results in an awful business culture that is highly self destructive. The norms formed by it are very powerful, which is the answer to the inevitable question of the libertarian is why doesn't a company defect and recruit the people dropping out of the rate race. Of course, these norms mean that you know before you even start that you are facing 60+ hour weeks, that you are expected to sacrifice your health and well being to the company, and that you need to show early on a willingness to put the needs of the company before your own to get to the top. This means that the best people never step forward, people suited for top management positions tend to be socially and group oriented and value their lives and families above the company, they are never in the running. There is no way to select for them because young people today know what is required of them and the best of them choose careers that will not demand this level of sacrifice, knowing the odds and having a realistic idea of the possibilities and sacrifices involved mean that you have to have a very specific type of personality to even consider aiming for a high powered career these days. So the company seeking to defect from these norms can't find anyone to select for because the people they need know better than to advertise the character traits that the rest of the business world is selecting against.
It's a huge collective action problem, a rather classic one actually, well explained in social sciences outside of economics. It's obvious that companies have developed norms designed to drive income to the top, to use this to motivate employees rather than to induce them monetarily, and that this serves to maximize profits for shareholders more readily than actually focusing on building long term careers for people while recognizing their other needs. It makes everyone but shareholders and winners of the career lottery worse off and since it is social and normative there is no way for markets to correct it. But while this can easily be observed through interviews or even through questionnaires it remains invisible to much of the economics profession.
*Most people in business seem to believe that this also helps to recruit quality people and get the most out of them, though I believe this is a bunch of self justifying bullshit and have yet to discover any methodologically sound evidence of this. Though there is a lot of self confirming nonsense of the form that everyone does this so it must be good, with no effort to reject the hypothesis that this is simply normative behavior disconnected from performance.
**Something I noted from a lot of my management classes is that the managers that outperform the average are people that are not on the fast track to top spots, they tend to be group oriented people unwilling to make the sacrifices required of a high powered career. They tend not to get noticed but in the cases they get tapped they perform well. Current selection methods do a great job at motivating and selecting for front line and mid level management but there are sharp discontinuities between what selects for these individuals best vs. what is necessary at the top. Since proven performance is what boards and managers are looking for by the time they are selecting individuals for the top spots there is no one ideal left because the selection methods used at earlier levels of the process have selected against all the good people. It's crazy, but that's what it is.