What determines levels of wages and salaries?
Traditional neoclassical economists have argued that workers’ pay is based on productivity. They argue that
W = MP
which in English means
Wages = Marginal Productivity
I am a sociologist, not an economist. There was an informal rule in the 1980’s and 1990’s that when sociologists wrote about wages, they were supposed to make snarky remarks about economists’ theories of wages, because supposedly labor economists knew nothing about wage determination. Wages were determined by “sociological factors” such as monopoly power, unions, cultural norms or the rules established by personnel departments. Those factors matter; there is a lot of evidence to back up the sociologists.
However, the logic relating wages to productivity is compelling, and there are plenty of concrete examples to back this up. Never mind the marginal part. That involves the elaborate math used by economists to justify using calculus in their work. Just think “average” productivity rather than “marginal” productivity.
If you are paid more than the value of your productivity, your employer is going to lose money on you. Unless your employer has a fat bank account and is willing to bleed money (some companies are actually like this), at some point your boss is going to have to get rid of you and get someone cheaper or more productive.
If you are paid less than your productivity, you are going to sense you are being ripped off. You may be trapped and this may be the only job in town. However, if your employer consistently underpays his workers, someone could show up who is willing to offer better terms. You leave and the employer has to look for replacements.
To be sure, there are a million exceptions to this. But there are a lot of crude differences in pay rates that are clearly productivity based.
Taylor Swift gets paid more than I do. Taylor Swift sells more music than any other musician in the country – and that includes all genres. (Yeah, this essay will look dated in 2032 when some other person is the latest biggest thing. But for now, the hot property is Taylor Swift.)
My doctor gets paid more than I do. The doctor charges insurance companies a lot for his services.
I get paid more than does a professor at Kerrville College. People come from all over the world to study at my university – Texas A&M. The quality of the faculty has a lot to do with this. The Kerrville faculty are not such a big draw. Likewise, the faculty at Princeton get paid more than I do. They are a much bigger draw – and they get more grant money to boot.
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Okay, Happy Happy Joy Joy.
We have now established that productivity has at least something to do with wage rates, even if they are not entirely the whole story.
Here is another wages = productivity story.
But it is not a pleasant wages = productivity story.
And it is not the story that economists usually tell.
Look at the following table:
Trends in CEO and Worker Compensation
Private Sector Non-Supervisory Workers, 1965-2017 (Constant Dollars)
In the last 60 years, CEO pay has absolutely exploded. Worker pay has gone up but not nearly so much. CEO pay has gone from less than a million per year to over seventeen million per year. Worker pay has gone up a little more than 25%. The pay gap has gone from 20 to 1 to nearly 300 to 1.
Naturally, this is because CEOs used to be only twenty times more productive than workers, right? Now they are almost three hundred times more productive than workers, right? So all this executive pay shows the amazing productivity of top executives in American industry, right? Workers are only slightly more productive than they ever were, so they get their deservedly small slice of the productivity pie, right?
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The story in the previous paragraph makes no sense. Even if Jeff Bezos and Elon Musk have done amazing things for their companies, there were super-executives in 1965 too. Thomas Watson was the President of IBM. Joseph Wilson was the President of Xerox. They too created business empires that completely dominated their industries.
And every period, there were mediocre executives as well. The figures in the table above include low-performing CEOs as well. If wages equal average productivity, how can the figures in the table above possibly exist?
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The answer involves stolen productivity.
Stolen productivity is no different than stolen wages.
How to allocate productivity among workers in a firm is not obvious.
Let’s take an easy case: sales representatives who record their sales. In theory, their productivity is how much each sales rep sold.
But what about the receptionist who took their calls?
What about the marketing manager who organized the campaign for the last month?
What about the IT person who kept all the computers and Zoom running that allowed the sales rep to make their calls?
What about the accounts where several people worked together on getting a big sale?
What about the product designer who improved the core products so much that the sales reps had an easy time making their sales?
Most workers contribute to the bottom line. (Okay, there may be a few slackers who are nearly useless.) When everyone contributes to the bottom line, dividing the spoils fairly at the end is a difficult and arbitrary task.
What is happening is that American productivity is going up overall. However, America’s executives are claiming more and more of the output for themselves. In essence, they are claiming they produced most of the productivity increase – and most of the rewards accrue to them. The most obvious mechanism by which this occurs is stock options. Anything that raises the price of a stock puts money into the CEO’s pocket – even if that increase was just due to a exogenous rise in the price of stocks overall. Bonuses that are linked to the price of company stocks have the same effect.
It is easy to see how top managers who allocate the returns to productivity can allocate the lion’s share to themselves. But why is this happening now? Why didn’t this happen in capitalism from the beginning?
a. Unions are weaker now than they were before. In the 1950’s and 1960’s strong unions held out for the workers they represented to get their fair share of productivity increases in improvements in wages. The weakening of American organized labor in the 1980’s and 1990’s took this voice of advocacy away from workers. Without collective bargaining, there is no one on labor’s side to haggle on behalf of their getting their fair share.
b. Mergers and acquisitions are more common than they were before. The CEO’s at acquired companies are usually given financial incentives to sign the papers handing their company over to a rival firm and then to go away quietly so the acquirer can run the company as it sees fit. Golden parachutes are financed by the revenues produced by the workers of the company. They go to the executive who is paid to get out of the way. Note that afterwards, the executives of the acquiring company will have “made their company more valuable” by virtue of their strategic acquisition. Even though that value was produced by the company’s labor force, the executives are rewarded for having created a bigger resource base. Mergers and acquisitions were much less common before the 1990’s. Banking deregulation vastly expanded the activities of investment bankers. The larger and more active investment banks of the 1990’s dramatically increased the volume of both friendly and hostile corporate takeovers … leading to these dramatic transfers of wealth to participating CEOs.
c. Production is more globalized. More and more manufacture is done overseas. American corporations acquire goods from subcontractors with whom they negotiate rock bottom prices. The big manufacturing companies and retail chains are oligopolistic brand name corporations. Apple, Walmart, The Gap, Dell, Amazon. The subcontractors are small micro-firms who compete in highly competitive markets. When large powerful buyers do business with small competitive sellers, they get the ability to buy cheap and sell more expensively. That monopoly power is not necessarily entirely the creation of the CEO although he may have played a role. The monopoly power does cut the foreign production workers out of their division of the spoils creating a larger share to be absorbed by the CEO.
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I don’t think the factors above entirely explain why so much income has shifted disproportionately to CEOs. But the factors above do play a role.
The larger headline story here is that the CEO’s ability to do this, hangs on the CEO’s ability to allocate the returns of the collective productivity of all of the workers in the firm in whatever way top management seems fit. Workers produce the value. They do not necessarily see the rewards from such production.
Productivity can be produced by one’s own labor. Or one can claim for oneself the productivity produced by others. This does not apply only to CEO’s. It applies to middle managers taking credit for work done for them by their secretaries. It applies to professors taking credit for work done in their lab by their graduate students. It applies to the loudest alpha males taking credit for ideas produced by female members of their teams.
Wages equal one’s claims of marginal productivity.
Stealing productivity is lucrative – and that is how a lot of people get rich.
For More Information
A balanced, even-handed and reasonable discussion of sociological factors that determine wages in Arne Kalleberg and Aage Sorensen’s article in the 1979 Annual Review of Sociology, “Sociology of Labor Markets”. Most of their essay addresses social factors that move wages away from levels expected from productivity.
My defense of productivity based models along with statistical analyses to back up the point can be found in my 1990 article in Social Forces "Market-Like Forces and Social Stratification: How Neoclassical Theories of Wages Can Survive Recent Sociological Critiques."
John Hick’s 1932 Theory of Wages contains a six-chapter defense of principle that wages equals marginal productivity. His discussion anticipates and counters many of the arguments that sociologists rediscovered in the 1970s and 80s. This is a two-sided war. If Hicks had been alive when the sociologists of wages were active, the sociologists would have been able to make their own counterstrikes as well. I would rate this battle a tie with both productivity and sociological factors playing a role.