Winner of the New Statesman SPERI Prize in Political Economy 2016

Wednesday, 13 August 2014

Inequality and the common pool problem

One observation from looking at the comments on my post on maximum wages was how many people just considered the impact of this idea on those with high wages, rather than seeing this as involving a redistribution of income.

The classic common pool problem in economics is about how the impact of just one fisherman extracting more fish on the amount of fish in the lake is small, but if there are lots of fishermen doing the same we have a problem. Those thinking about fiscal policy use it to describe the temptation a politician has to give tax breaks to specific groups. Those groups are very grateful, but these tax breaks are paid for (either immediately or eventually) by everyone else paying more tax. However the impact of any specific tax break on the tax of other people is generally so small that it is ignored by these people. As a result, a politician can win votes by giving lots of individual tax breaks, as long as each one is considered in isolation.

Discussion of the minimum wage often focuses on whether the measure is good for the low paid worker (e.g. will they lose their job as a result?). If distributional issues are considered, it generally involves the employer and employee (see for example the case of the Agricultural Wages Board discussed here). Sometimes discussion might stretch to firms doing something that could impact on other workers, like raising prices. However, if changes in the minimum wage have no impact on the overall level of GDP, higher real wages for low paid workers must imply lower real incomes for someone else.

The same logic can be applied to high executive pay, but it is often ignored. Here is part of one comment on my original post that was left at the FT: “the rise in incomes at the very top ... may be a worry in the dining halls of Oxford but in many decades not one person has mentioned such a worry to me. What worries people here, especially those at the bottom of the income distribution, is the decline in real wages …” But if higher executive pay has not led to higher aggregate GDP that pay has to come from somewhere.

Perhaps there is a tendency to think about this in a common pool type way. The impact of high wages for any particular CEO on my own wage is negligible. But that is not true for the pay of the top 1% as a whole. Pessoa and Van Reenen look at the gap between median real wages and productivity growth over the last 40 years in the US and UK. They have a simple chart (page 5) for the UK which is reproduced below. (The legend goes in the opposite direction to the blocks.) I’ll explain this first and then how the US differs.



In the UK over this period median real wages grew by 42% less than productivity. None of that was due to a fall in labour’s share compared to profits - called net decoupling in Figure 1. Most of it was due to higher non-wage benefits - mainly pension contributions in the UK - and rising inequality. There are two obvious differences in explaining the larger (63%) gap between median real wages and productivity in the US: the non-wage benefits were mainly health insurance, and in the US there is some decline in the labour share. However in both counties rising inequality explains a large part of the failure of median real wages to track productivity gains.

Unfortunately the paper does not tell us how much of this increase in inequality is down to the increasing share of the 1%, but a good proportion is likely to be. For example, Bell and Van Reenen find that, in the 2000s in the UK, increases in inequality were primarily driven by pay increases (including bonus payments) for the top few percent. “By the end of the decade to 2008, the top tenth of earners received £20bn more purely due to the increase in their share ... and £12bn of this went to workers in the financial sector (almost all of which was bonus payments).” If that £20bn had been equally redistributed to every UK household, they would have each received a cheque for around £750.

More generally, we can do some simple maths. In the US the share of the 1% has increased from about 8% at the end of the 70s to nearly 20% today. If that has had no impact on aggregate GDP but is just a pure redistribution, this means that the average incomes of the 99% are 15% lower as a result. The equivalent 1% numbers for the UK are 6% and 13% (although as the graph shows, that 13% looks like a temporary downward blip from something above 15%), implying a 7.5% decline in the average income of the remaining 99%.

So there is a clear connection between the rise in incomes at the very top and lower real wages for everyone else. Arguments that try and suggest that any particular CEO’s pay increase does no one any harm may be appealing to a common pool type of logic, and are just as fallacious as arguments that some tax break does not leave anyone else worse off. It is an indication of the scale of the rise in incomes of the 1% over the last few decades that this has had a significant effect on the incomes of the remaining 99%.   

25 comments:

  1. Yes I think it's extraordinary how this gets ignored (I am looking at you Deidre McCloskey).

    Perhaps because economists like to admonish those who think economics is a zero sum game, then don't like to talk about those aspects that are.

    Are we supposed to believe that some people get to consume 1 apple and some 1 million apples because those people have produced 1 apple and 1 million apples respectively? If not then it's better to think of some people capturing 1 millions apples and leaving only 1 for the rest.

    ReplyDelete
  2. The common pool problem exists in the aggregate time value we actually have. It is very limited, while resources separate from time are not. Does a high paid individual get paid for a service that we all need, that we need to utilize many of our hours in order to pay for? Granted, this is more of a problem in the U.S. where many need surgery in the course of a lifetime. Hence, the provider of surgery - because of high time use compensation, negates the time value of many others in the common (aggregate) time pool. But the solution is not redistribution because few offer the service while many need it. The solution is to allow all to heal, who have the capacity to do so. Or, allow each one to "fish".

    ReplyDelete
    Replies
    1. I have to admit I haven't quite understood the point that you are making. Is it that 'high value' individuals - like surgeons - create more potential value for the people they cure? And so are abstracting a proportion of the value that will be created by their cured patients?

      If so, and I'm really not sure, it's an interesting concept but difficult to extend a long way past surgeons. Should teachers be compensated based on the value of their pupils' lives?

      The problem is that some of our economic activity actually increases overall wealth, like surgeons or teachers enabling other people to live healthy productive lives, or builders building houses for people to live in, while other activity, like buying securities before the rest of the market realises there is an opportunity, or persuading borrowers to pay slightly more than they need to, does not obviously increase wealth. As it happens it's these latter activities that tend to be more highly compensated.

      THere's no obvious solution but what is certain, in my eyes, is that economics and its political implications have to be focused much more directly on the distributional impacts of policies and interventions. The classic output maximisation approach is only really relevant when there are genuine - not distributional - shortages to be addressed.

      Delete
    2. David,
      I have a concrete example in my life why I am concerned about the need for time use redistribution rather than money redistribution in common pools. I have been unemployed for some time and need to return to work at the age of sixty. My family would have helped me till I received Social Security, but decades of savings went to what Medicare could not cover for a final year of medical expenses. This is what I mean by healthcare subtracting from the time value of everyone else in a common time pool, a hole of negative aggregate time value which no amount of government redistribution can fill. Only consider how many years of family savings went to pay the medical bills! I want to live a long life, but without aggregate time value on the part of each individual, the additional time I want to live, still poses time use deficit problems for others. For me the solution is to gain additional time value from time aggregates, rather than just skimming profits from the most highly skilled.

      Delete
    3. Thank you for your frank response. I see more clearly now; the vocabulary is still strange to my ears but it makes sense.

      I will try to avoid references to US v. European models of health care, which seem to have a lot to do with your situation, and simply say that from a cold, heartless economist's perspective (which none of us are, of course), it's a question of personal income maximisation which will, of course, have nothing measurable to do with the high pay issue. However, taking a step back, there is something wrong with a society that on the one hand claims to value every life in it and on the other insists that most rewards go to those most able to grab them (and I mean grab: earlier posts from SWL and the comments attached have underlined that in most cases it is impossible to objectively assess the value added by individuals in a firm.

      Delete
  3. Your common pool analogy can be applied both ways: not just to taking small sums out of the large pool of wealth of the whole, but also to adding relatively small amounts to the large pool of individual wealth of the 1%.

    Increased executive pay doesn't just hit pockets directly; product quality and production location are important, as is the effect on the share price which then affects savings. But the principle makes sense, although perhaps more detail on the mechanisms would be helpful.

    As for "the impact of any specific tax break on the tax of other people is generally so small that it is ignored by these people" try living on the incomes of some of them and seeing how welcome a £400 income increase is, such as the raising of the Personal Allowance achieved. It might not be much for comfortably paid Oxford Professors, but for those on minimum wage, or even on anything below the National average wage, it's a different story. It could be the difference between needing a payday loan and not; between having meat today or not; between having an overdraft or not. Small amounts, but big effects - especially on consumption.

    It can even be argued that the tax cut for the 1% is the thing that actually makes no difference. It doesn't change how they vote and their lifestyle is unchanged by such a marginal increase in income. It might affect their savings, or their choice of supercar, but it actually doesn't end their dopamine addiction to always wanting more. Until these people realise that happiness comes not from ever increasing wealth, but from more human factors, they will remain in their fur lined rut of self-deception. They will continue to financially support politicians who will continue to push their agendas, but ultimately it will make no difference to them, just to the rest of us.

    ReplyDelete
    Replies
    1. You misunderstand what SWL wrote. A specific tax break for one group must sooner or later be paid for with a tax increase imposed on everyone else. The tax increase will be so small (because it is shared by so many people) that people may not even notice it.

      For example, if a tax break of £400 per person is granted to a group (let's say, taxi drivers) that comprises 1% of the population, the rest of the population will see a tax increase of about £4 per person. It is these £4 that SWL says will be ignored.

      Voilá! The politican has gained most of the taxi driver votes without losing any of the votes from the remainder of the population.

      Delete
  4. There has been so much effort by the press barons in the last generation to push trickle down 'economics' that when they have come up against a "my spending is your income and your spending is my income. If we both slash spending, both of our incomes fall" (Krugman blog via Keynes-Fisher, April 27, 2013 'The Ignoramus Strategy') their ability to continue lying their way through the present economic crisis has become trickier.

    The Tories haven't been elected since 1992, a Republican president looks a long way off; it's just the mess they've succeeded in making of the socially progressive parties that needs to be fixed.



    ReplyDelete
  5. It is fair to point out that the government mitigates the effect of rising inequality via the tax and benefits system. Pessoa and Van Reenen found a 20% mitigation of the gains of the top 1% and it might be greater now that some tax loopholes have been closed. But more importantly the growth of in-work benefits is helping the lower paid substantially. In fact one reason why wage growth is so slow is that there isn't much point trying for an extra £1 an hour because already steep marginal rates of benefit withdrawal have risen under austerity.

    ReplyDelete
  6. Dear Professor Simon Wren-Lewis

    Congratulations! You manage to produce a blog with intelligent themes and content and you manage to have persons to comment with very level of insight! Well done!

    Here are some mundane thoughts sparkled from your article:

    "a politician can win votes by giving lots of individual tax breaks"

    :: I feel that might be slightly different

    a) The politician in the best case is a competent person with good motives inside of a machine that uses him as public relations...

    b) I leave to you what is not the best case ☺

    "In the US the share of the 1% has increased from about 8% at the end of the 70s to nearly 20% today. "

    :: I feel that might be slightly different

    a) How is calculated wealth? Mostly is based in stock prices. How can a lucid person trust the the information that the stock prices transmit?

    b) How is calculated GDP? Mostly is based in some sort of "invoice". Put Keynesian (or the other face of the same thing: Marxists) running the show and then you will have "invoicing" going on in peace time (mostly to real estate cluster + war cluster) and in war time (mostly war cluster)

    "higher executive pay has not led to higher aggregate GDP"

    :: I feel that might be slightly different

    a) I wonder if there is some study comparing competence level and obedience level and executive pay. The executive is there to OBEY. His core core competence is OBEDIENCE. The competence it exists in lower levels of the organization. At moment is going one clear and public example of this in the margins of Atlantic strong river (ocean). It was transferred 900.000.000€ from one company to other without the CEO knew it!

    b) A human being is a human being... if they come with great ideas such as relativity, expanding universe and so on of course they deserve bonus, because they show truly competence otherwise bonus reflect mostly obedience at best or club-ism at the worse

    Note 1: This is a subject that I ALSO do not master
    Note 2: I have doubts
    Note 3: I make mistakes

    Please, educate me!

    ReplyDelete
  7. Income as a common-pool resource is definitely worth delving into more deeply. You just scratch the surface here and seem a bit halting about where it leads. The way that I've framed the issue is as labor-power as a common-pool resource. Elinor Ostrom hadn't considered that angle before thought it sounded worth pursuing.

    http://commonsandeconomics.org/groups/stream-2-labor-and-care/forum/topic/labour-power-as-a-common-pool-resource/

    Luis Enrique's comment about economists' aversion to zero sum games is apt, too. The situation is that some changes in income are zero sum games and some aren't. Because some aren't, economists see that as the more "sophisticated" assumption. But it's not either or.

    ReplyDelete
  8. http://www.degruyter.com/view/j/bejeap.2012.12.issue-1/1935-1682.3120/1935-1682.3120.xml

    ReplyDelete
  9. Gobanian,

    that paper looks interesting on strength of abstract, but I would expect a weak association between incomes in locations the rich happen to live in and the incomes of others in that location, because the cost of a CEO paying themselves lavishly is probably spread around all that company's employees (who could be getting paid more) and maybe also customers who could be getting charged less, and who needn't live in same place. So I not sure regional variation in the right thing to look at.

    ReplyDelete
  10. Luis Enrique writes:
    "Are we supposed to believe that some people get to consume 1 apple and some 1 million apples because those people have produced 1 apple and 1 million apples respectively?"
    Well this is exactly what neoclassical economics (subject to various - unrealistic - assumption) would have us believe. Return is exactly equal to contribution. There's more. An increase in income share for a group, such as the 1%, is exactly equal to the increase in its contribution (at least for market incomes). Of course this is nonesense, but it is what (in more or less literal form) many/most economists believe.
    So Simon, I fear it is not enough to say that the zero-sum game applies unless the income-sgare shift has raised aggregate GDP. The likes of Greg Mankiw would surely (and indeed have) argue(d) that it is all about skills-biased technical change and other factors that have increased the relative contribution of the already well off (with maybe a smidgeon of "rent-seeking" on top).

    ReplyDelete
    Replies
    1. Andrew: This idea is so implausible I refuse to mention it every time I write about this subject. My previous post on this issue, entitled bonus culture, covered this ground.

      However I will pick you up on 'neoclassical economics (subject to various - unrealistic assumption) would have us believe'. I also refuse to allow apologists for the 1% to expropriate my subject. Nowhere in the economics I learnt did it say that the real world is approximated by the idealised setup you have in mind. Neoclassical economics is also about monopoly, and information problems, that are likely to be acute when it comes to executive pay.

      Delete
    2. "Nowhere in the economics I learnt did it say that the real world is approximated by the idealised setup you have in mind."

      Agreed. Marginal productivity theory stipulates the very restrictive conditions under which factors of production would be compensated strictly according to their contribution. Ideologues pretend that those very restrictive conditions actually exist or they "define" them into existence with tautologies -- "no such thing as involuntary unemployment." Unfortunately there is a lot of trafficing in the latter sort of hand waving -- some of it highly esteemed by the profession.

      Delete
    3. Simon, in my experience the restrictive assumptions are often forgotten in much public discourse. This is (usually) not the case in debate between sophistcated economic thinkers, I agree. But then we need to ask how close are we to perfect competition. Greg Mankiw is certainly not an unsophisticated economist. If you (re)read his defence of the one percent (http://scholar.harvard.edu/files/mankiw/files/defending_the_one_percent.pdf) he very clearly says:
      1. Given perfect competition people earn their marginal product.
      2. In such case there is no need for redistribution (at times he says no need, at others he suggests redistribution would be actually wrong under such conditions)
      3. Government can/should correct market failures, because then distributive outcomes are suboptimal.
      4. These market failures are small, and so high and rising inequality is due overwhelmingly to exceptional talent paired with new technologies, rising relative demand for high-skills etc.
      And I think this is fairly typical. Things may have changed a little since the financial crisis, but for years and years those arguing for redistribution have essentially been forced onto a non-economic, "ethical" tack (disparities are simply unacceptable, undermine social cohesion etc.) because the consensus streching from magazines like the Economist, via the international financial organisations, to (previously) dominant economists such as Robert Lucas was so strong. So I agree with you that you can in principle take a "neoclassical" framework, if it is sophisticated, and argue for redistribution, but it does not happen often!

      Delete
    4. Andrew. I agree that people like Mankiw have been able to get away with this for far too long, but I also think things are changing. Just to make a couple of comments on your useful list:
      1. Perfect information is as important as perfect competition.
      2. This is, at best, an ethical judgement. However I think we now have good evidence that inequality is harmful for reasons that are well beyond the benchmark economic model, even if all its assumptions held.

      Delete
  11. How does this thinking apply to multinational companies like mine. The money to pay executives in San Jose comes from revenue around the globe.

    ReplyDelete
    Replies
    1. Err...it doesn't? Wait...I'm sure someone will figure out a way to apply it, lol.

      Delete
  12. Common Pools and Wage Funds -- A Reply to Simon Wren-Lewis (1 of 2)

    http://econospeak.blogspot.com/2014/08/common-pools-and-wage-funds-reply-to.html

    Simon Wren-Lewis raises an extremely important issue regarding Inequality and the common pool problem: "there is a clear connection between the rise in incomes at the very top and lower real wages for everyone else."

    Wren-Lewis explains the common-pool problem as being "about how the impact of just one fisherman extracting more fish on the amount of fish in the lake is small, but if there are lots of fishermen doing the same we have a problem." This needs a bit more explanation. The problem has to do with the difficulty of excluding fishermen (or limiting the catch of any particular fisherman) and with the limitation on the amount of fish in the lake. The essential reference on this is Elinor Ostrom's discussion of common-pool resources.

    Two caveats: difficult does not mean impossible and limited doesn't mean non-renewable or fixed in quantity.

    When it comes to income, it is easy to get lost in a money illusion. Yes, incomes are measured and paid in money amounts. But what they provide are rights of access to material things -- goods and services, "the power of purchasing; a certain command over all the labour, or over all the produce of labour, which is then in the market" (Smith).

    Nominally, the amount of income can increase without limit. But in real terms, increases in income are constrained by the amount of goods and services available in the market. That last qualification, the amount of goods and services available in the market, has led to a prodigious amount of confusion in economic thought. The classical wages-fund doctrine assumed that the amount of wage goods available at any given time was fixed. Accordingly, if one group of workers formed a union to enforce a wage increase, their gain would be at the expense of other workers.

    ReplyDelete
  13. Common Pools and Wage Funds -- A Reply to Simon Wren-Lewis (2 of 2)

    http://econospeak.blogspot.com/2014/08/common-pools-and-wage-funds-reply-to.html

    The amount of goods and services in the market at any given time is not fixed. But the key to the confusion is not the stipulated quantity but the imaginary temporal dimension of a "given time." Zeno's paradox of the arrow involves the same logical conundrum of dividing time into points.

    In 1869, W. T. Thornton argued persuasively that the wages-fund doctrine was erroneous and John Stuart Mill concurred and "recanted" the wages-fund doctrine. Exactly what Mill recanted may be in dispute but that is beside the point -- the classical doctrine was consigned to the dustbin of history of political economy. Or so we are told...

    By virtue of one of the most miraculous metamorphoses imaginable, the old wages-fund doctrine, used by polemicists as a club against unions demanding higher wages was transformed into the theory of the lump-of-labor, allegedly assumed by trade unionists, whose fallacy was used by economists as a club against unions demanding higher wages. "Heads I win" seamlessly became "tails you lose."

    But, getting back to Wren-Lewis, isn't his contention that higher executive pay "has to come from somewhere [that is, from the other 99%]" a reversion to the wages-fund -- or lump of labor -- doctrine/fallacy? No, it isn't. But this requires more explanation. There are not one, but two illusions at work here. One is the money illusion. The other is the point-in-time illusion. Combined, these two illusions constitute a powerful temptation to cognitive dissonance.

    To dispel those two illusions, let's first go back to Adam Smith's definition of wealth: "a certain command over all the labour, or over all the produce of labour, which is then in the market." 'Labor' appears to refer to a definite quantity and 'then' appears to refer to a definite point in time. Labor is not, however, a discrete distinction and a "point" in time is strictly conceptual.

    Just as with Zeno's arrow, no labor is performed in a "point in time." Labor can only be performed over a duration, be it an hour, a day, a week, a year or a lifetime. Furthermore, the amount of labor performed by one person during any interval of time is variable. It is not infinitely variable but it is flexible within certain definite limits. The expression labor-power indicates this characteristic of labor as potentially equivalent to a given quantity of production.

    So, we can now amend Smith's definition as follows: income represents command over a portion of the labor-power in the market during a given extension of time. This definition could be further refined but the point that I want to get to is that it is the labor-power that constitutes the common-pool resource. The amount of goods and services that corresponds to this amount of labor-power is not fixed -- but neither is it "infinitely" variable.

    The extent to which real GDP may vary depends on people's capacity to work, on their motivation and on their opportunities for employment, all of which may be affected by the distribution of income. In other words, great inequalities of income may well diminish the common pool of goods and services -- and ultimately of labor-power itself -- from which incomes are derived.

    That is, executive pay may be taking a bigger slice of a pie that is smaller than it would be if executives weren't taking such a big slice of it. Or to put it bluntly, they may be being richly rewarded for a negative contribution to social production that results from their excessive incomes!

    There is much more that can said (and has been said) about both the implications and the background of the analysis of labor-power as a common-pool resource. I will pause for now to see how the conversation unfolds.

    ReplyDelete
  14. Living in America, there is an added component to this equation that is kind of a zero sum game between the super wealthy .01 percent (that's where the real money is) and the rest.

    The Supreme Court has ruled that corporations are people with all attendant rights and with RELIGIOUS rights in the Hobby Lobby case. Hobby Lobby is a large corporation majority owned by less than 5 people. The court ruled that if a company is owned by 5 people or less it's free to discriminate based on religion.

    In the past few years corporate power has exploded versus the rights of workers in the USA. This concentration of wealth is eroding democracy at its very core. The Supreme Court, the US Congress, and partially the White House (yeah Geithner was a douche) are all bought and sold.

    We're in a vicious cycle as a democracy in the USA.

    ReplyDelete
  15. "But if higher executive pay has not led to higher aggregate GDP that pay has to come from somewhere."

    You left out the word "eventually", which is essential, and also unfortunately changes the practical effect beyond recognition.

    In the short run what the Übermensch mostly decide to do with their money is hoard it. There are tens of trillions of unspent dollars lying around, doing nothing, and hence in the short run, effectively not existing!

    The other thing they do is buy real estate, but they prefer it to be expensive. So they pay a vastly inflated amount for land in the places where rich folk are known to live, so the hoarded money moves from the account of one super-rich person to another, having zero impact on the rest of the economy. They are the same with most other things they consume: determined to pay more than necessary.

    God forbid any of them should actually try to get value for money from their trillions of dollars! Then several decades of pent-up inflation would presumably all arrive at the same time.

    ReplyDelete
  16. Interesting post, thanks.

    ReplyDelete

Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time.