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Supply and demand at work, or just good bargaining? The reality behind CEO pay

Supply and demand at work, or just good bargaining? The reality behind CEO pay

A report published by Deloitte a couple of weeks ago will have enhanced the feeling of holiday wellbeing for many people.

The median annual pay for bosses of FTSE 100 companies fell in 2018 to £3.4m, compared to £4m in 2017.

This is the lowest level since 2014, when the UK brought in rules which require firms to report a single figure for chief executive pay.

Criticism of the remuneration of top corporate executives has been growing strongly for some time. In June, for example, the shareholders of Netflix voted down – albeit by a very narrow margin – the firm’s executive officer compensation plan.

Netflix grew from nothing in 1997 to a current value of around $150bn, and over the last four years its share price has almost trebled. But shareholders still did not like the chief executive’s proposed package.

Top executives may feel rather aggrieved at this mounting unease over their “emoluments” – a much more suitable word for these grandiose packages.

After all, does not basic economics provide a sound justification for their pay? In the textbooks, prices are set by the interaction of supply and demand. If something is in short supply, such as the skills of executives, the price will be bid up.

Remarkably, a more sophisticated version of this argument is advanced by some leading members of the economics profession.

Greg Mankiw, a top Harvard economist, is one of the biggest cheerleaders. Technological change, he argues, usually increases the demand for skilled labour. As such, unless society is able to educate and train people so that the supply of skilled labour increases at least as much as the demand, the earnings of skilled workers will rise relative to the rest of the labour force.

Technology is further invoked by some to justify the pay of those at the top. Because of a truly dramatic increase in the level of connectivity in society, highly talented individuals have been able to leverage their talents across global markets and capture rewards that would have been unimaginable in earlier times.

This is certainly the case with stars of popular culture and sport. A hundred years ago, for example, the only people who could have any direct experience of Manchester United playing football live were those present in the stadium during the game. Now, the team can be watched by literally billions around the world, using a variety of delivery channels, and the players reap huge amounts as a result.

However, it is not at all apparent that the same argument applies to corporate executives.

The huge growth in business schools in recent decades, for example, has presumably led to a substantial increase in the supply of people capable of filling top executive roles.

The fact is that, in many situations, there is an inherent indeterminacy around a price – or a pay package – when it is being set. The Oxford economist Francis Edgeworth argued over a century ago that “in pure economics there is only one theorem, but that it is a very difficult one: the theory of bargain”.

Corporate executives have certainly exhibited great bargaining skills in recent decades. But it seems that, at last, their bluff is being called.

As published in City AM Wednesday 28th August 2019
Image: Handshake via pxhere licensed under CC0 1.0
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Retailers beware, the online shopping revolution isn’t going anywhere

Retailers beware, the online shopping revolution isn’t going anywhere

Another week, another retailer biting the dust. The baked potato specialist Spudulike has closed all 37 of its branches, with a loss of nearly 300 jobs.

Shopping centres are undergoing a sudden and dramatic squeeze, with many retailers only able to stay in business if granted a dramatic rent reduction.

Last week, Intu Properties, owners of the prestigious Lakeside and Trafford centres, announced a loss of £840m pre-tax. Net rental income fell by 18 per cent in the first half of this year.

Local authorities have become big owners of shopping centres to try to revive their town centres. But in most cases, the council taxpayer is taking a big hit. Shropshire Council, for example, bought three shopping centres in Shrewsbury early last year.

Their value has since fallen by over 20 per cent. The main reason is well known: more and more consumers are switching to the internet.

The latest estimates from the Office for National Statistics show that online sales now account for 18 per cent of all retail sales – and this is rising rapidly. In the year to October 2018, online sales grew 12.6 per cent. The only sector resisting the internet revolution is food, where the growth in online was only 1.8 per cent. The internet itself has been around long enough for a whole generation to have grown up unable to imagine life without it.

What is new is the surge in retail online activity in the past few years. The potential has been there for some time, but it is only now having a real impact. Why should this be?

Some 50 years ago, a larger-than-life Texan business school academic, Frank Bass, offered an explanation. He formulated a simple differential equation – and in differential equation terms it certainly is simple – which describes how new products get adopted in a population.

Bass made millions from his discovery, and it is still widely used in marketing circles today.

The basic idea is that people adopting a new product – in this case, shopping on the internet – can be classified into two groups. A fairly small set are innovators, those who are willing to experiment with something new. Most people are imitators, who wait and see how the innovators get on.

The speed of adoption, if it happens at all, of any new product is determined by the interactions between the two types of consumer and the degree to which they are willing to innovate or imitate.

Remarkably, given its simplicity, the model gives a very good account of the growth of a whole range of products.

In the early stages of a new product, growth is always slow. Almost all those buying are innovators. Then, suddenly, a critical point is reached. The imitators start to swarm in and growth becomes rapid.

Modern network theory offers a more sophisticated approach, but it is still essentially based on the motivations described by Bass.

Either way, the future for both retail and shopping centres looks bleak, unless they themselves find some dramatic way to innovate and alter their offer.

As published in City AM Wednesday 7th August 2019
Image: Empty High Street via Geograph licensed under CC BY-SA 2.0
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It’s not cutting-edge AI we should fear, but mediocre automation

It’s not cutting-edge AI we should fear, but mediocre automation
If there were a betting market in future winners of the Nobel prize in economics, MIT’s Daniel Acemoglu would be at pretty short odds. His highly innovative work has already won him a string of prizes. So his research is always worth following – especially when he challenges the conventional wisdom, as in his paper in the latest issue of the Journal of Economic Perspectives. Economists are usually optimistic about the impact of new technology. The innovation itself destroys jobs – the Luddite riots in the early nineteenth century, for example, were in direct response to the displacement of skilled handloom weavers by the new machinery in textile factories. But this, along with all subsequent waves of innovation, enabled goods and services to be produced more cheaply. As a result, the spending power of everybody else in the economy increased, and new jobs were created. Mass production in factories during the industrial revolution was of course a phenomenon without precedent in the history of the world. Other completely revolutionary technologies followed, such as the railways and electricity.  The rapid advance of robots and artificial intelligence seems to be the latest example of a transformative new technology. Acemoglu argues that it is not these “brilliant” (as he puts it) technologies which threaten jobs and wages. These enable things to be produced much more cheaply than before, substantially boosting real incomes elsewhere in the economy. Then new kinds of goods and services can be created as a result of the increase in spending power. Rather, the risk to overall employment and living standards comes from the introduction of “so-so technologies”, which generate only small productivity improvements. Examples of so-so technologies include automated customer service, which has displaced human service representatives. It is, however, generally deemed to be low-quality, and thus unlikely to have led to large productivity gains. The cost of your bank charges or your supermarket shop have not exactly been reduced much by the introduction of automated answering systems or self-service check-outs. But jobs have been lost as a result. Acemoglu suggests a key reason why modern economies have, as he puts it in the jargon, “moved along this [particular] innovation possibilities frontier”. In the US and also here in the UK, the tax system has evolved in ways which subsidise the use of equipment and penalise the use of labour through payroll taxes such as our employers’ national insurance contributions. Interestingly, he also points the finger at the big tech companies. Their business model is based on automation and small workforces. The impact of innovative technology which destroys particular jobs needs to be counterbalanced by innovation elsewhere, which creates new tasks, new jobs which no one had previously thought of. We have had some, such as software and app development and database design, but nowhere near enough. Governments need to rethink the tax system as it applies to investment and employment. And they need to rebuild support for long-term innovation, which gives more scope to invent completely new jobs.
As published in City AM Wednesday 8th May 2019
Image: Self Checkout by Ben Schumin via Wikimedia is licensed under CC-BY 2.0
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Want to tackle the scourge of fake reviews? The market can help with that

Want to tackle the scourge of fake reviews? The market can help with that
The internet has led to a massive increase in the amount of information available. Often, this is a good thing. For example, shopping around to find the cheapest price for something has become far easier. But it can have its downsides. A report last week from the consumer magazine Which highlighted one such disadvantage. An investigation claimed that the review system on parts of Amazon was being undermined by fake five-star reviews. The magazine analysed the listings of hundreds of popular tech products in 14 online categories, such as headphones and smartwatches. Researchers sorted the headphone reviews, for example, by the average scores of the brands. The first page of results – those with the highest scores – consisted almost entirely of little-known brands, with nearly 90 per cent of the reviews from unverified buyers. In other words, there was no evidence that the reviewer had ever bought the item in the first place. Companies like Amazon are well aware of these potential problems. They take steps to try to guard against them. A flurry of very good posts for a less well-known brand is one of the classic footprints which enable fake reviews to be identified. But Which suggested that the volume and variety of fake reviews was so large that the defences are currently being overwhelmed. A similar problem arose almost from the very start of email, when spam first appeared. Ever since then, a complicated evolutionary game has been played between the spammers and the spam filters. It is a game because spam wins if it gets through, and the filters win if it does not. It is evolutionary because both sides are constantly adjusting their strategies. The filters seem gradually to be getting the better of it, though I am currently being plagued by emails from China offering to sell me plastic moulds. The fake review – and more generally the fake news – problem has not been an issue for quite as long, but concern over it is growing. The instinct of many people is to reach for the law, and in particular to regulate. Set up a body, staff it with bureaucrats who of course have the public interest at heart, and the problem will be solved, goes the logic. The European Commission is a strong proponent of this approach. But there are already some good illustrations of the private sector reducing what economists describe as “reputation systems failures”. For example, a 2017 paper by Andrey Fradkin and colleagues at the MIT School of Management analysed experiments by Airbnb. A particularly successful one appears to be that of the simultaneous review: both the buyer and seller post their reviews, and only then are they allowed to see what was written about them. Not all consumers give feedback. Many who have a bad experience do not bother to rate the seller or product – they just stop buying from the platform. Platform providers therefore have a strong incentive to verify posts and encourage real reviews, perhaps using monetary payments to reduce selection bias. Just as we didn’t need to regulate against spam, given time, markets will find solutions to what is currently a pressing problem.
As published in City AM Wednesday 24th April 2019
Image: Online shopping by Maxpixel is licensed under CC0 1.0
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The intellectual imperialism of economics

The intellectual imperialism of economics

At this time of year, most people are focused on leisure. The holiday you have just had, the one you are on now, or the one you are just about to go on.

With exquisite timing, the 1 August issue of the top Journal of Economic Perspectives has a symposium of papers about work.

The opening sentences in the summary of the first of these reinforces the impression that economists can sometimes be rather unworldly. This is despite the fact that the author, Edward Lazear, occupies a chair at Stanford Business School and replaced Ben Bernanke as Chairman of the Council of Economic Advisors in 2006.

“Labor is supplied”, the summary proclaims, “because most of us must work to live. Indeed, it is called “work” in part because without compensation, the overwhelming majority of workers would not otherwise perform the tasks”.

It is an excellent illustration of the technique outlined by the 1950s British satirical writer Stephen Potter about how to gain the upper hand in a conversation about business. In his book One-Upmanship, he describes his ‘Economics B’ technique as the ‘Approach of Utter Obviousness’.

To be fair, the paper itself has real content. Lazear points out that economics as a science has made good progress in specifying how compensation and the forms in which it comes influences worker effort.

The results are sometimes surprising. For example, Bengt Holmström, the 2016 Nobel Laureate, concluded his Prize lecture with the statement that “one of the main lessons from working on incentive problems for 25 years is that, within firms, high-powered financial incentives can be very dysfunctional and attempts to bring the market inside the firm are generally misguided”.

The other two papers are much less about conventional economics. They focus on the psychology and meaning of work.

Greg Kaplan at Chicago and San Schulhofer-Wohl of the Chicago Federal Reserve examine how changes in the distribution of occupations since 1950 have affected the aggregate non-monetary costs and benefits of working.

The physical effort of work has obviously declined a lot over the decades, so that is a benefit. But the authors find that the emotional impacts of the changing occupation distribution vary substantially across demographic groups.

Compared to 70 years ago, work has become happier and more meaningful for women, but more stressful and less meaningful for men. And most of these changes are concentrated on workers with lower educational qualifications.

The final paper, by Lea Cassar of Cologne and Stephan Meier of Columbia is even further removed from the traditional areas studied by economists. They tackle the massive topic of work as a source of meaning in people’s lives.

The authors develop an initial theoretical model which incorporates the three psychological needs at the basis of self-determination theory: autonomy, competence, and relatedness. Intriguingly, they suggest that the concept of meaning at work can be examined using existing tools in economics such as labour supply theory and principal-agent analysis.

Economics has a strong streak of confident imperialism. Increasingly, it intrudes into a wide range of other social sciences.

As published in City AM Wednesday 15th August 2018

Image: Holiday by Pxhere is licensed under CC0 1.0 Universal
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Our automated future is brighter than Karl Marx or Mark Carney would ever suggest

Our automated future is brighter than Karl Marx or Mark Carney would ever suggest

Mark Carney, the governor of the Bank of England, hit the headlines at the weekend, claiming that Marxism could once again become a prominent political force in the west.

Automation, it seems, may not just destroy millions of jobs. For all except a privileged minority of high-tech workers, the collapse in the demand for labour could hold down living standards for decades. In such a climate, Communism may seem an attractive political option.

Karl Marx as an economist is a bit of a curate’s egg, good in parts. In the late eighteenth and early nineteenth centuries, it was obvious that the system of factory production was dramatically different to anything which had ever existed, but it was thought that might disappear just as suddenly as it had emerged.

Marx was the first major economist to see that the accumulation of capital in factories represented a new, permanent structure of the economy: capitalism. He developed a theory of the business cycle, the short-term fluctuations in economic growth, which is much more persuasive than the equilibrium-based theories which dominate academic macroeconomics today.

But he was completely wrong on a fundamental issue. Marx thought, correctly, that the build-up of capital and the advance of technology would create long-term growth in the economy. However, he believed that the capitalist class would expropriate all the gains. Wages would remain close to subsistence levels – the “immiseration of the working class” as he called it.

In fact, living standards have boomed for everyone in the west since the mid-nineteenth century. Leisure hours have increased dramatically and, far from being sent up chimneys at the age of three, young people today do not enter the labour force until at least 18.

Marx made the very frequent forecasting mistake of simply extrapolating the trend of the recent past.

In the early decades of the Industrial Revolution, just before he wrote, real wages were indeed held down, as the charts in Carney’s speech show. The benefits of growth accrued to those who owned the new machines. Marxists call this the phase of “primitive accumulation”.

But such a phase has characterised every single instance of an economy which enters into the sustained economic growth of the market-oriented capitalist economies, from early nineteenth century England to late twentieth century China.

Once this is over, the fruits of growth become widely shared.

In fact, Carney’s own charts give grounds for optimism and contradict the lurid headlines around his speech. One is headed “Technology driving labour share down globally”. In other words, the share of wages and salaries in national income has been falling. In the advanced economies, this was some 56 percent in the mid-1970s and is 51 percent now. But all the drop took place before the mid-2000s. If anything, the labour share has risen slightly since.

Similarly, inequality has increased over the past 40 years, but almost all the increase took place in the 1980s. Depending which measure we take, it has either stabilised or fallen since 1990.

The future looks more optimistic than either Marx or Carney suggest.

As published in City AM Wednesday 19th April 2018

Image: Car Factory by Jens Mahnke is licensed under CC0.0
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