“Incentives to produce” are incentives to rig the game
That’s obvious, right? But let’s belabor the point.
All too often in discussions about the vast dispersion of circumstance we call “inequality”, people concede a kind of trade-off. Yes, reducing rewards to those at the top of the wealth/income distribution might blunt their incentives to produce. But the cost of that might be offset by utilitarian benefits of transfers to the less well off, or by greater prosperity engendered by MPC effects on aggregate demand, or by whatever.
That’s all well and good as far as it goes. But at current margins, I suspect (with Paul Krugman) there is no tradeoff. There might be a tradeoff in measured GDP, but GDP happily tallies economic coercion and rent-capture along with genuinely productive activity. Suppose that a comic-book evil pharmaceutical company secretly unleashes a disfiguring virus for which — miracle of miracles! — it has an expensive, patented treatment. After the pandemic, consumers would have a choice: tolerate an odiferous oozing eczema (but remain otherwise healthy and productive!), or pay for the treatment. GDP would likely rise! In macroeconmic terms, this kind of thing is an example of the “broken window fallacy“. Causing a disease and then expensively treating it does not in fact make the world richer. But it may well inspire economic activity — the mass production of a new drug, visits to doctors, extra hours people choose to work in order to afford the treatment, etc. In aggregate, we work harder just to stay in place. But the distributional effects of the operation are very real. The extra personal income enjoyed by the conspirators spends nicely.
In real life, it’s not so common for comic-book villains to release icky pathogens and then charge for a cure. But it is very common for doctors to restrict entry into their profession and to act politically to inflate the cost of their services. Goaded by “incentives to produce”, participants in the financial industry do a lot of “innovating” that amounts to finding ways of skimming invisible or unexpected fees from people, or persuading customers to bear underappreciated and undercompensated risks, or maximizing the value to them (and costs to others) of guarantees implicitly or explicitly provided by the state. Nearly every industry hires lobbyists to carve out favorable loopholes and subsidies and regulatory schemes at everyone else’s expense. Tech firms make a business model of invasive surveillance and selling information about people who are their users but not their customers. Patent trolls send extortion letters to users and creators of new technology. Politicians “revolve” out of government into perfectly legal, extravagantly compensated sinecures in the private sector, and then often back into government. Senior members of the military become “private sector entrepreneurs”, garnering contracts from friends and former colleagues in a burgeoning defense and intelligence industry, often for work that used to be performed more cheaply internally. Executives collude with friendly boards who rely upon transparently idiotic consulting practices to extract huge salaries. Some of these things contribute to measured GDP, to “growth”, but their effect on the actual well-being of those outside their industries is, um, questionable.
This stuff isn’t marginal, nor should we expect it to be. In fact, we should expect the prevalence of rent capture (or worse) as a source of economic profit to increase with technological progress. Why? Because, absent chicanery, technology increases the ease of production and the efficiency of distribution. As Schumpeter pointed out, the source of profit in real-life capitalism is the fact that monopoly power is ubiquitous because of natural barriers to competition. The corner store has a monopoly on the convenience of its neighbors, and so can capture some of the surplus that might otherwise be bid away to customers by competitors. On-demand delivery drones would eliminate that monopoly. Yet the corner store industry might lobby to prevent residential rooftop deliveries, in which case it is no longer exploiting a natural inefficiency but capturing a rent. In business school, students are taught that a successful business has a “moat” that makes it difficult for competitors to bid away ones margins. Technological progress renders moats that derive from nature harder to come by. Instead, successful businesses — and successful people (since under capitalism, a human is just a small business) — must rely increasingly on moats that result from social and political arrangements. We choose to grant monopoly rights to “creators” in the form of intellectual property and to expand their scope. We choose to limit the taxi business to medallion holders. We choose to prevent Indian doctors from competing in American hospitals, even though airplanes have eliminated locals’ natural monopoly. We choose to hire from the Ivy League. The distribution of profits is determined by social choices rather than by natural scarcities.
None of this is to say that any particular such choice is “wrong”. The static inefficiency inherent in patent monopolies at least under some circumstances may be overcome by the incentives to invent they yield. Minimum wage laws are restraints on competition that I enthusiastically support precisely because of to whom the “rents” are directed. Maybe sending a gigantic, very random fountain of money to producers of health-care inputs via an inscrutable hodge-podge of public and private payers really is the best way to ensure our cancers are cured before we are diagnosed with them. Who knows?
But the distribution of affluence is less and less a matter of direct attachment to production, and more and more a function of winning social games and political contests that determine to whom the fruits of production will be allocated. There’s no conspiracy in that. Nor is it an answer to say “capital” now determines who enjoys wealth. As technology improves, capital goods become mere commodities like everything else. Financial capital, whatever it is, is not an input into any material production process. It is a construct and artifact of a huge and ever-changing array of social and legal institutions. “Human capital”, “social capital”, and “organizational capital” are things we impute ex-post to winners of distributional contests as explanations of observed returns. They do not straightforwardly exist in the world.
“Inequality” — high dispersion of outcome — creates a strong incentives to be on the side of winners. There are some circumstances where being on the side of winners means making an outsize contribution to economic production. There are other circumstances where winning means aligning oneself with coalitions capable of winning legal and political contests that may be orthogonal to, or much worse than orthogonal to, any contribution to production. The two strategies don’t preclude one another. Perhaps outsize rewards are shared between those who make unusual contributions to production and those who participate in politically potent guilds. But, at best, increased dispersion increases the incentive to engage in both sorts of behavior. Incentives to produce are also incentives to contest for rents. And at any given time, for any given person, one may be an easier or more reliable means of gaining outsize rewards than the other.
Suppose, reasonably I think, that ceteris paribus humans prefer to “be good”. That is, we prefer to do work that is productive and engage in behavior that is ethical. Suppose, also reasonably, that a well ordered society depends upon people sometimes making choices opposed to their material interests on ethical or other grounds. Then it is obvious how inequality might be costly. Instead of talking about “incentives to” (produce, extract rents, whatever), we might describe outcome dispersion as a tax on refraining from mercenary behavior. If the difference between economic winners and losers is modest, people of ordinary virtue might refrain from participating in activities they consider corrupt, might even be willing to “blow the whistle”, because the cost of doing so is outweighed by their preference for behaving well. But as outcome dispersion grows, absenting oneself from or even opposing activities that would be personally remunerative but socially undesirable becomes too costly. The required sacrifice eventually overcomes a ceteris paribus preference for virtue. Preventing the misbehavior of large coalitions is a collective action problem. An isolated malcontent or whistleblower is likely to be evicted from the coalition without meaningfully improving behavior, if others choose to “circle the wagon”. Outcome dispersion both increases the costs to individuals of engaging in pro-social behavior, and diminishes the likelihood that bearing those costs will be fruitful, since others will have strong incentives not to follow.
Wouldn’t it be odd to live in a country where, say, bankers individually acknowledge that their industry often behaves destructively, where insiders perceptively describe the conditions that create incentives for people to take bad risks or fleece “muppets“, but continue to work in those places and do nothing about it? Wouldn’t it be odd to live in a country where doctors privately apologize for the way their services are “priced“, but nevertheless take home their paychecks and pay AMA dues? Or in a country where economics instructors teach agency costs using textbook pricing as a case study, during a course for which students are required to purchase a $180 textbook?
I don’t mean to criticize anyone in particular. (I used to be the economics instructor.) In all of these cases, there really isn’t anything any one individual can do to remedy the bad practices. Making a big issue of them would lead to useless excommunication. Instead we shrug ironically. In our society, an ironic attitude is a token of sophistication (a telling word, which once meant corruption but now implies competence). An ironic attitude towards collective ethics is adaptive. It helps basically decent individuals participate in coalitions that ruthlessly contend for rents. But perhaps we’d have a better society if, rather than turning our ethical discomfort into an object of aesthetic consideration, lots of us worked straightforwardly to remedy it. And perhaps more of us would do so if the risk of losing our place were not so terrible. Ethical behavior is endogenous. “Inequality” renders it costly.
- 29-Mar-2014, 6:00 p.m. PDT: Struck near duplicate: “…treatment, etc.
GDP rises!In aggregate…”; “hodge-podge of public and private institutionspayers“
- 23-Sep-2015, 3:40 a.m. PDT: A bunch of small edits: “participants in the financial industry do a lot of ‘innovating’ that amounts to finding ways of skimming invisible or unexpected fees from people, or persuading
themcustomers to bear underappreciated and undercompensated risks, or maximizing the value to them”; “as an explanationexplanations of observed returns”; “agency costs with case study ofusing textbook pricing as a case study“; “for which students wereare required”.