The allocation of income and wealth: power versus marginal productivity

John Kay has written a fine account of the distribution of the rewards created within an economic enterprise in his FT column today.  Reflecting on the rewards of looters in the London riots, and allocation of resources in professional services (“eat what you kill”), he comments:

“Two broad economic theories describe the allocation of income and wealth. The power theory states, broadly, that people get what they grab: from the forest, the markets, or the shop window. The distribution of income reflects the distribution of power. For most of history, this was plainly true – the landlord took what he could from the tenant, the baron what he could from the landlord, and the king what he could from everyone. The sixth Duke of Muck was rich because the first Duke of Muck had been an especially successful gang leader. The alternative theory is that what people earn reflects their marginal productivity – how much they personally add to the value of goods and services. The marginal productivity theory has many attractions, especially to those who are well paid: if what they receive is a product of their own efforts, their rewards are surely well deserved.

“Collaborative organisation was only occasionally necessary in an agricultural society in which there were no asset-backed securities and no electrical goods in the shops. But in a complex modern economy, as in the deer forest, production requires the involvement of many. Adam Smith marvelled at the resulting efficiency in his description of a pin factory. But if, as Smith described, one man wrought the iron and another stretched it, who could say what was the marginal productivity of each? And what was the marginal product of the chief executive of the pin factory, or the person who hedged the foreign exchange exposure on the unfinished pins, whose contributions the Scots savant unaccountably failed to mention?

“If the pin factory really did increase the productivity of the factory by a factor of at least 240, as Smith claimed, there was likely to be a surplus when the wage earners had received whatever their marginal product was. And when it came to dividing that surplus, the distribution of authority within that pin factory would be crucial. That distribution would surely favour the CEO. Since the CEO wrote – or at least commissioned – the pin factory’s annual report, the moral and economic argument could be turned on its head. If you were paid a lot, that showed that you contributed a lot. What the recipient earned was, by that fact alone, justified. So the ethic of just reward through effort gave way to the culture of present entitlement from possession.”

So how does this relate to the Escondido Framework?  After all, the Escondido Framework is about organisations and is underpinned by the idea that organisations are defined by their external market interfaces.

The market defined the minimum reward that must accrue to the wage earner, or the CEO for that matter, since if the rewards are insufficient the wage earner will move to alternative employment (after due allowance for the frictional expense of changing jobs, issues surrounding risk and uncertainty about joining an unknown organisation).  But given that the Escondido Framework recognises that most markets are imperfect, the firm that operates more efficiently than competition (so that Adam Smith’s pin factory enjoys at the very least an experience curve advantage over competitor pin factories) for whatever reason may be able to generate returns above and beyond those required to pay the market clearing prices in its markets.  Who gets the additional return: investor (only if he remains sufficiently engaged to address the agency problem of relying on a manager), the manager (whose position mirrors that of the investor), a monopolist supplier exploiting the leverage from his control over scarce resources, the wage-earners (particularly if their skills are in short supply or they organise into a union), or perhaps the customers if the pin factory if has high fixed costs, spare capacity and no alternative markets to serve, or if the company’s strategy is to defend market share by keeping prices low to discourage competition?

John Kay’s observations about the privileged position and likely hold on power of the “CEO” of the pin factory are characteristically perceptive.  All that is needed to reinforce the upwards pressure on rewards arising from the circular argument that high pay must indicate greater contribution is a remuneration committee displaying the Lake Wobegon effect and setting out to pay top quartile in the believe that those with the highest pay deliver more than those of their peers on lower salaries.