Contracts, wage-setting and inequality

The modern market economy depends upon voluntary exchange between people selling what they have to offer and buying what they need. Workers sell their problem-solving skills and ability to get things done, and employers pay them a wage in return. That’s the beauty of the market. Alas, markets are not very effective in ensuring that everybody ends up with the same amount of stuff.

​We begin by clarifying what is meant by 'the market'.

When we talk about ‘the market’ we mean something more. We mean the complex system in which people buy and sell, offering money, goods, labour, time and abilities. We all participate in it, day by day, in our roles as workers, customers or investors. As Adam Smith said, more than two hundred years ago, in a post-feudal society ‘every man…lives by exchanging, or becomes in some measure a merchant.
 
Lisa Herzog, Inventing the market: Smith, Hegel and political theory, p. 1.
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​In a market economy the function of law is to eliminate barriers to free and fair competition, to protect property rights, and to facilitate contractual agreements. In light of the voluntary nature of joint enterprise, the allocation of corporate profit is decided by agreement and regulated by the principles of contract law. Within the corporation, the residual decision-making rights are vested in shareholders, with managerial control over day to day decision-making vested in a board of directors elected by shareholders. Shareholders typically bargain for a residual entitlement to the profits, taking what is left after the other contracting parties have been paid such fixed sums as agreed in their contracts. Workers in turn sell their labour to the firm for a pre-determined wage. Economic efficiency plays a dominant role in explaining why the law adopts this approach:

[to reduce] the ongoing costs of organising through the corporate form by facilitating coordination among participants in corporate enterprise and constraining value-reducing forms of opportunism among the constituencies of the corporate enterprise.
 
Reinier Kraakman et al, The Anatomy of Corporate Law (OUP, 2009) p. 2
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This contractual framework accords workers a growing degree of autonomy over the terms on which they offer their labour, especially in the digital age where creativity and flexibility in how we work is so important. The growing value of human capital has greatly weakened the old ‘take it or leave it’ or ‘just sign on the dotted line’ form of employment contract. Dinosaur corporations that cling to the old ways of treating workers like minions who do as they are told are going…well, they’re going the way of the dinosaur. Savvy employers are increasingly aware that corporate success depends on the contribution of employees with the specialized skills and information such as ‘product and industry knowledge’ and ‘client relationships’ that must be nurtured and encouraged. The old factory floor method of just barking out orders simply doesn’t work any more. In the modern ‘knowledge economy’ the corporation relies on intellectual and cognitive exchanges between employees within and between firms, so that creativity and flexibility in taking initiative to invent new solutions are highly valuable skills.
 
As knowledge inputs are increasingly important for corporate productivity, and knowledge production itself constitutes the firm’s main output, wage levels are increasingly determined by the firm-specificity and sophistication of knowledge of the workers. This creates a ‘knowledge hierarchy’ (Powell and Snellman, 2004). The result is that not all workers earn the same wage, as those with greater informational expertise are paid more than those with generic knowledge. The traditional ‘pay scale’ where an attempt is made to achieve uniformity by paying uniform wages to groups of workers within the same ‘band’ is coming under increasing pressure.

This is very worrying for those whose main concern in life is to ensure that everybody earns the same wage and that nobody becomes richer than 99% of the world’s population. Given the concerns about income inequality and the growing gap between the high-waged and the low-waged, especially as there are many angry people out there, regulatory questions arise on two axes: first, in relation to the degree of legal regulation that is desirable or indeed justifiable without undermining negotiated contractual settlements; and second, identifying the point at which income disparity becomes unsustainable, thereby calling into question the fairness of wages and the legitimacy of self-regulation in wage-setting.

In evaluating the fairness of wages, the assumption is that perfectly competitive free markets will ensure that workers are paid a fair return for their work; if they were underpaid they would simply go elsewhere and work for an employer who recognizes their value. Of course, in the real world, we know that markets are not perfectly competitive. People get stuck for various reasons and cannot move away from the stingy employer. Or the employer may simply fail, for various reasons, to evaluate accurately the value contributed by each employee. In large corporations where people work in teams, the problem is compounded, and it may be easier for the employer to just fix a pay scale and pay each team member the same wage rather than make the futile attempt to figure out who is contributing what. Hence economists concerned about income inequality point out that wages do not necessarily reflect the marginal productivity of any individual worker. This difficulty is compounded in relation to workers with managerial roles: 

When an individual’s job functions are unique, or nearly so, then the margin of error is much greater. Indeed, once we introduce the hypothesis of imperfect information into standard economic models…the very notion of ‘individual marginal productivity’ becomes hard to define.

Piketty, Capital.
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Going further in his critique of marginal productivity, Moore argues that this idea 

​materially misrepresents how individual performance-based rewards actually operate within productive team environments…it is – under ‘real world’ productive conditions and informational constraints – inherently impossible to discern the distinct relative value of individual worker inputs to the overall productive output of any collective team operation.
 
Marc Moore, ‘Corporate Governance, Pay Equity, and the Limitations of Agency Theory’ p. 5
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Many corporations avoid the difficulties inherent in measuring marginal productivity, and the associated monitoring costs, by evaluating performance solely by reference to stock market performance. Yet this carries the risk of incentivizing managers to engage in excessive risk taking or adopting unduly short-term horizons that sacrifice long-term productivity and growth.

So, there are many problems and challenges in the way that markets set wages. Yet in addressing these challenges, the correct question is not whether markets perfectly set wages (Editor: we are all grossly underpaid, except for the bankers, who are grossly overpaid) but whether proposed changes would offer an improvement without overriding associated costs. We could agree that corporations suck at setting fair pay, the evidence being all the overpaid executives out there bringing their yachts out for the summer while the poor continue struggling on their pittance wages. How infuriating. But does it follow that it would better to appoint an official to fix everybody’s wages, so we can all be more equal and less consumed with envy? Wouldn't it be easier and cheaper and much more fun for everyone to just try not to be so envious of other people? It's not compulsory to go on the rich kids of instagram to work yourself up into a froth about the wasteful excesses of those with more money than sense.

Adding fuel to the fire is the return of profitability of major banks, whose lavish pay scales at the top make ordinary people (and not a few professors) drool with envy. So we face this challenge. How exactly can regulators constrain pay without wrecking the entire financial sector?
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The operative norm should be that businesses are imperfect and governments are worse. Accordingly, the lesser (and cheaper) evil is for government to let firms set compensation levels. It is better for our high-profile experts to do nothing than to do something dumb. So into today’s political climate, expect something dumb.

Richard Epstein, ‘Executive Compensation Follies’, Forbes, October 27th, 2009.