Minimum Wages and Maximum Wages― Why the Determination of Worker Pay is so Poorly Understood

Published May 29, 2018

Public debate about the minimum wage seems to creep up every election cycle. Most recently, Seattle’s push for $15-an-hour minimum wage by 2019 has received a lot of attention. But thanks to the Dodd-Frank Act public debate is now concerned not just with minimum wages but maximum wages. Under the 2010 law, firms are now required to disclose pay ratios between the CEO and the average worker. Ostensibly a rule to inform shareholders, the effect of these new disclosures rules has been to stoke the flames of class warfare. With every story of CEOs making 100 times, 500 times, 5000 times the average worker, it seems there’s whispers for government to do something about it. To wit: DNC Deputy Chair Keith Ellison has argued for a cap on pay in excess of twenty times worker averages.

What is interesting about these stories is that economics tells us that its probably not the realm of public policy to worry about how much workers are paid.

Why is that? Well, economists believe workers are paid according to the value of their productivity― not their skin color, sex, attitudes, interests, political opinions, or luck. It’s a cold, calculating decision based on how much a worker can produce per hour of labor.

In light of current pay differentials, this means that CEOs would need to be extremely productive to justify their wages. Economists tend to think they are. One class of extremely productive workers might be the “entrepreneur.” According to economist Israel Kirzner, entrepreneurs are visionary, imaginative, have a knack for taking good risks, and can anticipate the wants of consumers. In other words, a profit seeking CEO can effectively “peer around the corner” before anyone else. Just like how most people can’t dunk like LeBron James― no matter how hard they try― most people simply don’t have this kind of entrepreneurial insight. Not only does this mean entrepreneurs will be richly rewarded, but society is better off because our wants are fulfilled at low cost.

As a contrast, economist Joseph Schumpeter conceives the entrepreneur as an innovator, someone who commercializes an idea. The firm itself is the physical manifestation of this idea. Think of Facebook, eBay, or the assembly line. When you or I don’t work, someone fills our shift. When an entrepreneur doesn’t work, our very jobs don’t exist because their ideas were not acted upon. Workers are typically not creative in this way, and so their pay reflects that. They might do creative things, such as designing a product or finding time saving techniques, but most workers are fundamentally subservient to someone else’s idea― they do what their bosses say, when they say, for whom they say, and follow templates. Indeed, it is the CEO that created those templates!

Either way, for many this idea of “workers paid according to their worth” seems all too simple. After all, don’t some employers make mistakes, or perhaps have a “taste” for discrimination? Economics also reassures these skeptics: firms that don’t pay workers correctly are punished by the market. Firms that don’t measure productivity accurately, don’t monitor workers, nor devise suitable employment contracts will simply die out. This intense competition, or persistent “survival of the fittest,” ensures that firms acting in their own self-interest will further the public interest in the long run.

We tend to think wealth creates itself or cutting edge products appear on their own accord. Yet it is entrepreneurship and the freedom to act entrepreneurially that brings about this prosperity. Is society better off being “equal” in pay but with no iPhones? “Equal” but without drone technology dropping goods to our doors? Interfering with how firms pay workers amounts to the destruction of wealth― distorting how firms use scarce resources and choking off the fruits of entrepreneurship.

It’s then intuitive, but wrong to think restricting CEO pay will improve social wealth. Wage rates and pay differentials are rational, efficient and wealth producing― the best public policy solution, therefore, is just to get out of the way.