What Determines Your Earnings?
By Chang Se-moon
Professor of South Alabama University
On July 26, Michael Vick, who is a star quarterback of the Atlanta football team, pleaded not guilty to the illegal holding of dog-fighting charges against him. We do not know whether charges leveled against him are true or not. It will be determined by the trial that will begin during the week of November 26, this year.
Our interest in today’s article is limited to how much he earns. When he was selected in 2001, his contract was for $62 million. In 2004, Vick signed a 10-year, $130 million contract, averaging $13 million a year. If the lucrative advertising deals that he signed were included, Vick’s annual earnings would average much more than $13 million a year.
In the U.S. corporate world, I can count many more than 40 executives who earned more than $10 million during 2006. It is difficult to find salaries of business executives in Korea, but I would not be surprised to find several Korean business executives who earn more than $10 million a year. Wouldn’t it be nice if we all made $10 million a year?
Well, life is not designed that way. In the United States, the federal minimum wage was raised from $5.15 per hour to $5.85 per hour on July 24, this year. Annualizing the minimum wage, it increased from $10,712 to $12,168 per year. There are millions of workers in the U.S. who make no more than these minimum wages. In fact, most Korean females who visit the Working Woman's Network for assistance are reported to earn about $10,000 a year.
There are two issues that I would like to explain in today’s article. One relates to what determines how much people earn, and the other relates to whether people really deserve more than $10 million in annual earnings.
First of all, let me explain what is supposed to determine how much people make. Let us assume that we are operating a small noodle shop near the historic Duksoo Palace in Seoul. Assume that a bowl of noodle sells for $5.00, or about 5000 won.
Assume also that we are so busy that we consider hiring another person who can increase our sales by 10 bowls per day. The 10 bowls of additional sales are called the marginal product of the new person we consider hiring. Bowls of noodle are products, and the 10 bowls are marginal in the sense that they are additional sales beyond and above existing sales. This explains why economists call them marginal products.
The dollar value of additional sales is $5 times 10 bowls, which is $50. The $50 is the additional revenue that the new employee is expected to bring for our noodle shop. The $50 is called the marginal revenue product. The marginal revenue product is simply the money value of the marginal product. If the cost of making the 10 new bowls of noodle is $10, the net profit that the new employee will bring to our noodle shop is $40 per day, which is obtained by subtracting $10 of cost from $50 of additional revenue.
If the daily wage to the new worker is less than $40, we will be increasing net profits to our noodle shop by hiring the new worker. The amount of increased net profits is $40 minus wages paid to the new worker.
Stated in simple terms, how much people earn depends on how much money these people generate for the employer. In other words, you are paid what you are worth. This is known as the marginal productivity theory of income distribution. Basically, we all believe that it is a good system since there is nothing wrong with people getting paid what they are worth to their employers.
The problem is that this theory requires perfect competition to be totally valid and the market is far from being perfectly competitive. Perfect competition, in turn, requires perfect information.
Let us return to Michael Vick’s earnings. The marginal productivity theory appears to tell us that if Vick brings $13 million or more in revenue to the Atlanta football team each year, he deserves $13 million pay.
This is not exactly true. Assume that Vick generates $15 million per year. Since he is paid $13 million, he generates $2 million of net profit for the Atlanta football team. What if the team hires another quarterback who can bring in $10 million, but is paid $5 million a year?
The team’s net profit, then, increases to $5 million per year. Does the Atlanta football team calculate profits under all different scenarios? Not likely.
Let us return to earnings to corporate executives all over the world, including Korea and the United States. Mr. Ray Irani of the Occidental Petroleum was paid $52,143,188 in 2006, including salary, bonus, and other monetary benefits. The question is not whether Mr. Irani increased Occidental Petroleum’s net profits by at least $52 million, but whether Mr. Irani’s contribution to Occidental Petroleum’s net profits is greater than contributions to Occidental Petroleum that could be made by another executive who is paid less than Mr. Irani’s pay.
There is no clear answer to the question, because any such comparison requires data that do not exist. The reality is that earnings of highly-paid individuals such as Vick and corporate executives are determined by educated guesses of other people who are in power to make such decisions. Usually, these people are the same people who earn a large amount of money.
The opinions of rich people are biased in favor of higher pay, because the higher the pay of other executives is, the greater their own pay is likely to be. Just imagine what will happen to their own pay if they decide to cut pays in half for all other executives.
It will be a matter of time before their own pay will also be cut in half.
The point is that undoubtedly there are executives and athletes who are worth a lot of money and probably worth more than what they are paid. Overall, however, the pay of many, if not most, corporate executives and athletes is too high for their productivity because the way the pay of executives is determined is inherently biased in their favor.
Let us now turn to the second question of whether people really deserve more than $10 million in annual earnings, assuming that the high pay accurately measures their true contribution to their employers. The answer really depends on the collective judgment of society. This is one of many issues that cannot be answered with economic theory alone.
Clearly, incentives should not be taken away from people who are productive. Just as importantly, society should take care of its people who cannot take care of themselves for many reasons. Some are mentally ill, while others are permanently injured fighting for the country. Some are too old to be productive, while others are too weak physically to make a living. Some are born in such poor families that they have to work while they are young, rather than get an education.
My thinking is that wealthy countries, which include Korea, should be able to afford to take care of the weak and the poor and still be able to allow enough incentives for productive people to continue to be productive. What do you think?