There are few areas in which real-world economics diverges more from introductory econ theory than in how salaries are determined.
If a factory hires one more worker who increases sellable output by $100 per day, then $100 is the maximum amount the manager would be willing to pay that employee. The $100 is the “marginal revenue product” of one additional day of work. It also is one point on the employer’s “demand curve” for labor. That, together with supply, or the number of workers willing to do particular jobs at different compensation levels, determines market salary levels.
The theory goes on to say that in a perfectly competitive free market, every worker will earn this “marginal revenue product” of his or her labor. If some people earn more than others, it is because what they produce is of greater value to society.
Take that and bounce it against the reality that a local TV news anchor in my area earns more than $500,000, while the wife he is divorcing might earn $37,000 as an inexperienced schoolteacher. Or that the new president of my state’s flagship university will earn $610,000. Or consider the $90,000 in annual disability payments that a congressman gets from Delta Airlines because sleep apnea keeps him from working as a pilot.
Do all of these highly compensated people really make that large a contribution to society?
Our first answer would be that in the real world, the necessary conditions for perfect competition — many buyers, many sellers, no monopoly power, a uniform product, etc. — seldom hold true. When they don’t, compensation and value produced for society are not necessarily equal.
For example, while there is competition in TV news broadcasting, stations can still have considerable market power. The need for a federal license constitutes a “barrier to entry” into the business. So stations earn monopoly profits making it possible to pay large salaries for key talent.
What about university presidents' salaries? As with TV stations, large universities are limited in number. Nearly all are nonprofit, so they lack the market-driven cost-containment incentives of the television business. Big 10 education certainly isn't perfect competition.
All this raises the question of why salaries for presidents of big-name universities have outpaced those of faculty, just as pay for local television personalities has risen so much faster than other professions. The same is true for sports stars. The ratio of the pay of the biggest stars, compared with the average for other pros in the same sport, has risen sharply in recent decades. Ditto for corporate CEOs, at least in the United States.
This question, “the economics of superstars,” is fascinating to economists and has spawned a whole subfield of research within labor economics. It contributes to the increasingly unequal distribution of income in U.S. society as we move to what some economists term a “winner-take-all economy.”
Economist Edward Lotterman teaches and writes in St. Paul, Minn. Write him at ed@edlotterman.com.
