DECEMBER 20, 2014
ECONOMICS took a hit after the financial crisis, with good reason. For the last 50 years, much of what got published in economic journals was highly mathematized rationalizations of free market theology, the equivalent of medieval monks arguing about the number of angels dancing on the head of a pin. At the height of the boom, a number of academics actually “proved” that in a free market system, bubbles were impossible. One economist took his faith so far as to assert that if you looked at it a certain way, bulbs were correctly priced during the famous 1660 tulip bubble, even though at its peak one flower was worth more than an Amsterdam townhouse. This conviction required a spectacular ability to ignore reality.
For too long, a talented economist, or at least one who got tenure, spent his time constructing models that, starting with implausible assumptions (we are all omniscient rational agents with perfect information about all prices past and future), made elegant and logically consistent conclusions. (It doesn’t matter whether a company is financed through debt or equity.) Whether these theories have any connection to the real world has little relevance to an economist’s professional success. Before the crash, most macroeconomic models didn’t even include a banking sector. That is like physics without gravity.
This trust in theory gives neoclassical economics a distinctly Panglossian flavor. As long as markets are free, we live in the best of all possible worlds. According to the orthodox economics taught undergraduates, every one of us — you, me, the bum pushing a cart full of Coke cans, Lady Gaga, Donald Rumsfeld, Rupert Murdoch — all earn precisely what we deserve. The logic is impeccable. No one would pay a worker more than they contribute to the firm’s bottom line, and no worker would labor for less than he makes the firm. Thus, assuming, as neoclassical economic models do, perfect competition and everyone’s omniscience of all probabilities, present and future, we each earn exactly the marginal productivity of our labor. Even entrepreneurs, ultimately, will earn precisely what their labor is worth, what a worker hired to do their labor would get paid.
That is because, in neoclassical economics, unlike real life, profits are merely a temporary phenomena. Any business making above average gains will draw in competitors, increasing supply and thus driving down the price until its profits reach the point of equilibrium, at which point its earnings are the same as those of every other businessman. This, I was told when I studied Econ 101 as a college freshman, was the justification of capitalism. No one gets to charge more than he deserves. Ultimately, all progress accrues to the consumer.
Beating up neoclassical economics for making ridiculous predictions on the back of absurd assumptions is probably too easy. Joseph Schumpeter, the great Austrian economist, has a more nuanced understanding. For Schumpeter, the entrepreneur is capitalism’s hero, the risk-taker whose innovations propel our economy forward.
By creating a new product, finding a new market, or discovering a more efficient method of production, Schumpeter claims that an entrepreneur can, for a time, make exceptional profits. These excess profits, Schumpeter agrees with the neoclassicals, won’t last forever. As soon as others copy the entrepreneur’s techniques, supply will increase and so prices will decline until profits equal the wages of a hired worker doing the same job.
Schumpeter’s florid prose does make entrepreneurs sound like Nietzschean supermen rather than our more commonplace vision of middle-aged men in suits talking enthusiastically into phones, worried about selling enough widgets every month to cover their nuts. Schumpeter would claim that our widget wholesaler is just a “businessman,” the “entrepreneur” a more distinguished subset of the group, the innovator with new techniques or new technologies that allow him to make supernormal profits.
Of course, in common conversation, the businessman and the entrepreneur are synonyms: that is to say, the individual directs a business enterprise, and unlike employees does not earn a regular wage, and unlike lenders does not receive regular interest payments. The entrepreneur or businessman then is the person who collects the residual profits of the business after wages, interest, and other expenses are paid.
Profits above the standard, according to Schumpeter, exist only as a reward for innovation. This is poetic, and certainly more compelling than neoclassical mathematics, but does not strike me as how the world actually works. We often believe what we read but we believe more wholeheartedly what we experience. My experience, as both a worker and as an entrepreneur, tells me that better than normal profit is not dependent on innovation.
Please allow me to give you a personal example.
For a number of years, I made my living filming “talking heads.” A television network would hire me for the day, I would drive out to their station, pick up their camera equipment, along with a soundman also hired for the day, drive their truck to a location, haul the gear to some pundit’s office, set up the lights and camera, and film our subject blathering about whatever topic the news director found compelling that day. For this work, depending on what union penalties might be incurred, I would earn around $400.
One day, I received a phone call from a former client. For a very important corporate presentation, she needed to film some expert pontificating about I can’t remember what. She did not have camera equipment, a location, or a soundman she knew to hire. She wanted me to put together that package and film the talking head. I charged her $5,700. Deducting the pay of the soundman and the makeup artist, the rental of the camera equipment, and the price of the hotel room where we would do the filming, I cleared $3,850 — that is to say almost 10 times as much as I would have had I just been hired to do exactly the same job as a worker rather than as an entrepreneur. The extra work involved less than an hour on the phone, calling various suppliers. It is unlikely that that hour on the phone was worth $3,450; if we assume that my work as a cameraman has the value of $400 that my regular employer paid, what else did I do that allowed me to make this supernormal profit?
Innovation had nothing to do with my extra pay. I was doing nothing more innovative than the day before.
In part, my profit came from marking up expenses. Asymmetric information allowed me to know more about my costs than did my client. I told her that the soundman cost $450 when he actually earned $350, the makeup artist cost $600 instead of $450, and the gear $1,200 rather than $900 — but this would only net me another $550. We still have $2,900 to explain.
Let us be clear: my activity as a worker, knowing where and how to place lights to provide the most pleasing picture, required more artistry, talent, and experience than my activity as an entrepreneur, which merely required looking up phone numbers and calling suppliers. Yet it was as an entrepreneur that I made most money.
This overpayment of the entrepreneur is not an anomaly. Donald Trump does not design his own buildings, and he borrows the money to build them, yet he makes much more than his architect or his banker. No one wants to see a small-time Mafioso take his clothes off, but as owner of the club, he makes more than his prettiest stripper. Nijinsky danced better than Dagaliev, but Dagaliev retired to Monaco. For years I alternated between work for hire and entrepreneurial activity, doing essentially the same tasks, and I always made much more money as an entrepreneur.
This then is the paradox: it is the workers who bring skill, experience and talent. It is the banks that risk their capital. Why does the entrepreneur make most of the money? Neoclassical economics denies that they do. Austrian economics recognizes entrepreneurs make more than workers, but only for a limited period, and merely as a reward for their innovation.
I suggest reality is a bit more complex and that entrepreneurs make more than workers for at least three reasons: 1. Economic rent; 2. Scarcity of risk takers; 3. Social conventions.
Perhaps one of the most useful, albeit underutilized, concepts in classical economics is Ricardo’s economic rent. Confusingly, it has nothing to do with landlords or apartments. In plainest language, economic rent is about getting paid more than you deserve, that is to say, more than your marginal productivity. In the 1970s, conservative economists accused unions of “rent seeking,” of extracting more value from firms than they contribute. Today, the same thing could be said of bankers.
We have two definitions of economic rent. From one perspective, rent is the difference between what you are paid and what you would require to be paid to perform the service. So if a film actor says, “I would do this for free,” his entire $10 million fee could be considered rent.
The other way of looking at rent is the difference between the price paid and the opportunity cost. So if the land under a Texas oil field didn’t have derricks on it, and its best other use would be as grazing land for cattle, the rent would be the difference between the income from oil and the income it could earn as grazing land.
David Ricardo came up with the concept during the Napoleonic wars, when demand forced up the price of grain, making its production profitable on land that previously would have lain fallow. That is to say, land in Yorkshire, which could only produce grain profitably at £15 a bushel, comes on line when grain hits that price. But, land in East Anglia, which would happily produce at £10 a bushel, now collects rent (also called producer surplus or supernormal profits) of £5 a bushel.
My client needed her talking head to look great. The success of her meeting (and thus perhaps her job) depended on it. She could have called a well-established production company, with high overhead, which probably would have charged her around what I charged. Since I had almost no overhead, and had a firm grasp of prices of suppliers, I was a much lower cost producer and so I was able to capture the rent, just as the East Anglian landlord was able to in Napoleonic days. From the opportunity cost perspective, had I not been working for her, I would have been shooting for a client who hired me as a cameraman and so the rent would be the difference between the $400 earned as a worker and my $3,850 profit.
Schumpeter is correct in asserting that entrepreneurs are fundamentally rent-seeking creatures. But Schumpeter was romantic in thinking that only innovation (i.e., finding new ways of doing things that lower costs or increase quality or create a new good or market) is the source of rent. Much more common is what his fellow Austrian Friedrich Hayek called the “particularized knowledge of time and place.” An entrepreneur makes his living from that knowledge, from a profound local understanding of demand, suppliers, and price.
To return to my example, I knew how important this job was to my client. I knew how much established companies would charge her. I knew how cheaply I could perform the service she required. It is this specific knowledge of clients and suppliers, of cost and price, that generally enables entrepreneurs to capture supernormal profits.
Hayek too, was romantic in assuming that this particularized information would quickly become embedded in prices, that lower costs would flow from the businessman to the client. Asymmetric information allows the entrepreneur to use his greater knowledge to capture rent. Schumpeterian innovation, of course also provides the opportunity for rent capture, but it is the exception, not the rule.
The next explanation is more flattering to entrepreneurs and rewards them for the courage with which Schumpeter correctly endows them. Many projects fail. Few of us have the faith in our own intuition and the willingness to work wholeheartedly for an uncertain reward. Again, a few examples from my own life.
In the late 1970s, I thought it would be cool to watch a network that showed music videos. Unfortunately, I didn’t think anyone other than my friends and I would watch it, so Bob Pittman, instead of me, invented MTV and made his fortune. In the ’80s, when my colleagues were borrowing money to buy camera equipment, I was frightened of paying a large monthly nut to the bank. Instead, I kept on renting gear, and now my colleagues who bought cameras own beach houses and I do not. In the ’90s, I discerned a market for documentaries about ordinary people. I wrote a few proposals, flogged them to HBO, but when I did not get a prompt response, I went back to my more immediately income-generating activities, and so when Big Brother aired, I had nothing to do with it.
It is not enough to think of an idea, or even to pursue it desultorily; the entrepreneur’s profit goes to the person who is willing to commit his time and energy to projects that may not succeed. Workers are guaranteed their salaries, lenders are guaranteed their interest, but the entrepreneur has no guarantee: he just collects all the money that is left over. That could be a fortune or it could be less than nothing at all. Most of us don’t want to take this risk. Part of the reason entrepreneurs are well rewarded is because they are scarce.
This explanation, of course, fits neatly into conventional neoclassical logic of supply and demand. It also validates Schumpeter’s claim that entrepreneurs create progress in an economy. Without someone with faith in his or her insight and the courage to pursue it without certain reward, we would have neither MTV nor Big Brother, nor even the personal computer.
Perhaps most underestimated is the role of culture in determining price. Econ 101 tells us that price is determined by the intersection of the supply and demand curves. This suggests that the reason 23-year-old investment bankers make more than starting teachers is there is an undersupply of potential investment bankers and an oversupply of primary school teachers, relative to demand. Clearly, this is not the case. Starting bankers’ higher pay can be explained in part by their more stringent qualifications and longer work hours, but can also be understood by three other factors: the amount of money flowing through the system, history, and culture.
Considering the massive sums traded every day in our capital markets, the high wages for starting bankers are trivial to their employers. The more money that flows through a system, the more one can charge for the same service. A plasterer explained to me why he charges more for the same work in Manhattan than in Brooklyn: “People in Manhattan have more money.” A receptionist at an investment bank will make more money than a receptionist in a dentist’s office, even if they have the same qualifications and do the same job.
History is also vital in determining price. Plumbers are paid more than electricians in part because plumbers have always been paid more than electricians. Investment bankers make more than teachers because by now that seems the natural way of the world. Businessmen make more than workers because they always have.
In the Middle Ages, theologians believed every item had a “just price.” The more modern notions of supply and demand have shattered that conception, but I suspect on some level, we have a sense of what each occupation’s wage should be and we assume entrepreneurs have a greater right to higher pay than do ordinary workers.
Even our modern markets retain some characteristics of an Oriental bazaar where the merchant and the customer eye the carpet, and each other, knowing their own maximum and minimum price and deciding how far the other will go to make the sale. We all know the carpet merchant will sell more cheaply to his cousin than to a stranger and to a local than a foreign tourist. Because of the respect that businessmen and entrepreneurs receive relative to workers, negotiations on wages seem to be much more fierce than they are on price for a complete service. Workers, even skilled workers, are seen as interchangeable cogs, commodities to be paid the commodity price while entrepreneurs are seen to be providing a specialized service whose price must negotiated much more gingerly.
Other businessmen accept more readily that a fellow businessman deserves to make a good profit while they see the workman’s pay coming out straight out of their bottom line. At least in my experience, I found clients much more ready to accept a higher price for my labor when embedded in an entrepreneurial service, rather than an even lower price when they saw me just as hired help. The individuals hiring the starting bankers (who themselves had been starting bankers only a few years earlier) don’t mind paying the 23-year-olds $150,000 a year rather than the $75,000 they could probably get away with. Since so much money flows through their industry, an extra $75,000 to make everyone feel better about themselves seems cheap.
Adam Smith and the great classical economists who followed him discovered their insights by examining the world. Modern economics has become abstract, divorced from our everyday experiences. This does not mean that economics is bunk. We do know a great deal about how the economy functions. For example, every economist — indeed every finance professional knows — the effects of raising interest rates on share prices, unemployment, GDP, inflation, and the strength of the currency. This knowledge, however, is not mathematical or precise or based on logic. It is more like a book of aphorisms or even a cookbook than like a geometric proof.
The great Alfred Marshall, the man who invented supply and demand curves, and the author of the textbook that was economics for several generations, said that economics was “the study of humanity in the ordinary business of life.” What could be more vital for us to strive to understand?
I do not claim to have done anything, but begin to explore the reasons why returns to entrepreneurs seem higher than economic theory tells us. However, it is vital for us to not simply accept the dogma about the workings of the economy, but to compare it to our own experience of the world.
The financial crisis has taught us economics is too important to be left to the economists.