On the Side of the Angels

Economists, Protest and Positional Rents by David Collard

For the RES Newsletter, January 2012, Online Issue 1

At a time when rewards to top bankers and others are subject to popular protest, David Collard, at the University of Bath, argues that economists should be less keen to defend the status quo by showing more awareness of the role of economic rent in the setting of higher level rewards.

Occupations of Wall Street and the City of London have been mainly about income distribution, the People versus Bankers. Or ‘who gets hold of the stuff?’ But here’s a paradox. Economists know more than almost anyone else about the warts and imperfections of the labour market. So, in spite of being pretty well paid, they should be on the side of the angels. Yet they are widely perceived by demonstrators and protesters to be apologists for ‘the system’. I believe this is partly because spokespeople from business or finance, many of them with degrees in economics, automatically resort to a simple ‘default’ theory of distribution. They are, as Keynes might have said, seized of a powerful theory.

The powerful theory in question is usually some version of marginal productivity theory. Under competition, allocative efficiency is satisfied when a worker’s wage rate equals his or her marginal value product. And the wage also just compensates the worker as it measures the (money value) of the marginal disutility of effort. Or, if you prefer, the real wage equals the marginal rate of substitution between income and leisure. So the outcome is doubly satisfactory: it balances value to society against subjective cost to the individual.

 Picking holes in the default theory is not difficult. Any first year student could do it (externalities, monopoly, zero-sum activities, etc.) The particular hole I would like to pick here concerns positional rents (analogous to positional goods). The world to which the default theory is applicable has been a shrinking one: the upper echelons of pay in the public and corporate sectors have long contained elements of economic rent. Those who set pay have been able, just like aristocratic landlords, to ‘cream off’ a layer of revenue before it gets distributed to the ‘factors of production’. These positional rents are not quite the same as Marshallian quasi-rents as they do not necessarily get competed away. The personnel might change but the positions do not. The mechanics whereby positional rents are preserved are by now fairly well-known. Inter-locking remuneration committees often operate as ‘clubs’ and design attractive packages (or ‘compensation’) for chief executives and the tier immediately beneath them. Investment funds (supposedly guarding shareholders’ interests) are not exempt. Public sector institutions (even universities) then look for comparators (based on indicators such as budgets) for their own chief executives. Sometimes an international bench-mark may be found. These rewards seem to be only loosely linked to success or failure and hardly at all to personal risk-taking. Soldiers and surgeons take risks: on the whole chief executives do not.

Ricardo famously observed that ‘a tax on rent would affect rent only; it would fall wholly on landlords and could not be shifted to any class of consumers’ (Principles, chapter X). Economic rent fits well with the classical notion of a ‘surplus’: but it has never sat happily with our default theory, the neo-classical theory of distribution. The ‘adding-up’ problem was elegantly solved at the end of the nineteenth century (using a theorem due to Euler) in a fashion that seemed to preclude a fixed factor earning rent. The popular classroom device of the Cobb-Douglas production function (or its close relation the CES) commonly uses two factors, human and physical capital. Again, rent has no place. This rent-less treatment of both production and distribution provides a framework for most of our macro-models.

If the view taken here is correct, that is to say positional rents are important, several implications follow.

  1. There is no presumption that positional rent bears any relation to marginal value product (this is a fortiori the case if the activity is a zero-sum game).
  2. On the other hand by definition the positional rent will be above marginal supply price.
  3. To the extent that high pay contains a positional rent, taxing it cannot have significant output effects.
  4. Policies for public expenditure or income redistribution, financed by taxing positional rents, cannot be finessed by disincentive arguments.
  5. Traditional arguments for economic justice may be allowed to carry more weight, since the implied trade-off between efficiency and equality is not so sharp.
  6. Recent arguments that more equal societies (for example, that those with flatter earnings structures are happier ones) also carry more weight.

In short my plea is for a more explicit role for economic rent, not merely in popular versions of the default theory but in our professional work. That might have the effect of making us less up-tight about taxation and more sympathetic to the half-formed economics-of-the-street. To paraphrase Dr Johnson, ‘there are few ways in which a policy-maker may be more innocently employed than in stripping the rich of their positional rents’.

From issue no. 156, January 2012, p.14

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