Wednesday, 17 October 2012

Just what do they teach at Waikato? (updated x3)

This is from The Herald and is written by Ryan Wood who is a history student at the University of Waikato.
This is where the maximum wage comes in. If the top salary is legally fixed at, say, $200,000 a year, these economic miracle-workers running companies will have no choice but to start their own businesses where, as shareholders, they can indulge in the dividends they deserve. The creation of new companies will in turn lead to more jobs, thus negating the need for any "starting-out" wage.

A maximum wage also has a trickle-down effect. The millions of dollars that would have been paid to CEOs could instead be paid as bonuses to workers, or used to lift the average wage of employees at the company. These people could then spend their extra income, further supporting the economy.
This is so wrong for so many reasons. First, what happens to the businesses that these CEOs leave? Assuming these CEOs are better at running those companies than an alternative manager (if they are not why did they get the job in the first place?) then when these guys leave that firm will perform worse than it is now. If they are less efficient what happens to the employment levels at these firms? Second would these people really start up new firms? Why not just go overseas where they can get paid what they are worth? The market for company managers is international. This means that to get the best we have to pay the going international wage. A lower wage just means we would have less able managers running our biggest companies. As an example consider the problems of getting good managers for cooperatives which often have flat pay scales and limits on how large the CEO's pay can be. Ricketts (1999: 20) explains the problem as "[f]urther, to minimise antagonism a rough equality in the division of the residual will be necessary and this may conflict with outside opportunities. Those with high transfer earnings reflecting high productivity elsewhere will desert the co-operative." Jossa (2009: 709-10) explains the basic issue in terms of the management of capitalistic versus co-operative firms: "[g]iven the tendency of cooperatives to distribute their income equitably among all the members, it is difficult to deny that few cooperatives are in a position to pay the high salaries that able managers can expect to earn in capitalistic firms. Whenever a group of people resolve to work as a team-we may add-the member who outperforms the others in initiative and organizational skills will inevitably take the lead. The crux of the matter is that such a person has no incentive to establish a cooperative and share power and earnings with others. He or she will prefer to found a capitalistic firm, where he or she will hold all authority and, if sole owner, appropriate the whole of the surplus [references deleted]. Thirdly, I would assume that Wood assumes there would be more small firms in the economy. What does this mean for economies of scope and scale. Firms are big for a reason, and reducing the size of currently large firms or making them less efficient - see above - doesn't help the economy. Fourth, Wood says that,
The millions of dollars that would have been paid to CEOs could instead be paid as bonuses to workers, or used to lift the average wage of employees at the company.
Except this assumes that the same level of profit will be made after the CEO leaves the company as before, but will it? Not only are profits likely to be lower due to less able mangers running the company but the incentive effects on lower level mangers will also be reduced. Part of the reason lower level mangers work hard is to became the top guy. But if its not worth becoming the top guy given that the benefits of being at the top have been reduced, why work hard? Fifthly, Wood assumes that demand is what matters for the economy. He writes,
These people [workers] could then spend their extra income, further supporting the economy.
Even if workers marginal propensity to consume is higher than that of managers this just means their marginal propensity to save is lower and thus we get less saving in the economy. And aren't we always being told we don't save enough? Six, if big firms become less efficient, what happens to our exports? Many of our biggest firms are exporters and they would become less competitive. Seven, one way to make an manager act more like an owner  is to use some form of performance pay. This aligns the incentives of the manager with those of the owner. Basically you make the manager's pay dependent on the profits of the firm. Have, say, a base wage of $200,000 and then make up the rest of the competitive wage via some type of performance pay which gets around whatever regulation is put in place. This would be much like the manager of the firm being the owner and getting the dividends of the firm. A lower basis wage would mean a higher performance component to the wage. The problem here is that, as has been shown via sometimes bitter experience, performance pay can have unintended consequences and lend to more risk-taking by the managers along with other measures to manipulate the factors that are included in the performance part of his pay package. All this can negatively effect the performance of firms, in extreme cases bankrupting them. Next, Wood argues,
The creation of new companies will in turn lead to more jobs, thus negating the need for any "starting-out" wage.
But the argument for a "starting-out" wage has nothing to do with the number of firms or jobs, its about the productivity of workers. Young workers just starting out in employment are less experienced and skilled and therefore less productive than older workers. The lower wage they get reflects this lower productivity. If you have to pay a low productivity worker the same as a higher productivity worker it is the latter that you will employ.

Update: As far as the exCEOs will become entrepreneurs argument is concerned, it should be noted that they had this option even without the incentive offered by the maximum wage and didn't take it. Given they don't appear to want to be entrepreneurs is the wage limit really likely to be enough to get them to change into entrepreneurs rather than just moving out of New Zealand to continue with their preferred option? An additional point I should have made when discussing the effects on exporters is the effects on those firms which compete with imports. If they become less efficient then we could not only lose jobs among out exporters but also among import substitution firms.

Update 2: Welly Gnome writes on the Dunce of the Week: Ryan Wood and Kiwiblog writes on A maximum wage.

Update 3: On the idea that managers may not become entrepreneur I should have remembered this footnote from a paper of mine on the difference between the skills and personality types of managers and entrepreneurs.
"See, for example, McCelland (1961) and Beugelsdijk and Noorderhaven (2005) for discussions of the link between personality type and employment preferences. Fuchs-Schundeln (2009) looks at the preference for being self-employed and finds that the self-employed report higher job satisfaction than the employed. Hartog, van Praag and van der Sluis (2010) compares the effects of cognitive and non-cognitive abilities on the performance (measured by income) of entrepreneurs and employees. Their results show a markedly different returns for entrepreneurs and employees. Bandiera, Prat, Guiso, and Sadun (2011) show that managers' risk aversion and talent are correlated with the incentives they are offered and, through these, with the characteristics of the firms that hire them. So managers with different characteristics are matched with firms with different characteristics."
In other words its not clear that managers and entrepreneurs would want to be in the role of the other.


Mark Hubbard said...

While I understand the maximum wage was a sad inevitabilty from the minimum wage, I rather hoped I might not have seen it discussed seriously in my life time.

Eric Crampton said...

Shouldn't we be beating up on the NZ Herald for printing something stupid written about economics by a history student rater than beating up on a history student for being clueless about economics?

Paul Walker said...

No we should be beating up on both. But you do rise a good point, just why did the Herald publish such a clueless piece?!