Friday, April 17, 2015

Income Inequality

Nobel and I don't seem to agree much these days. First Obama. Then (no) Kirzner. Then Piketty.

I think at a minimum, they should require people to explain their positions before being considered for a prize. Piketty, for example, seems to have watched enough MSNBC and Fox News to master the art of scare-mongering soundbites. He has also mastered the art of economic analysis of large data sets. However, I've yet to see him effectively connect those two things. In other words, he really hasn't been able to convincingly show that his data supports his soundbites. Larry Summers, for one, agrees.

To wit,I've been thinking about his position on income inequality. Think about the amount a product or service can be sold for as a function of:

raw materials + labor inputs (human or machine) + intellectual inputs (human or machine) + profit (or loss)

Each of those inputs has an associated dollar value, but it also has a contribution factor. For example, people pay a lot these days for fancy tasting menus at top-notch restaurants. The meat and veg and spices to compose the meal might contribute 20% of the cost. The chef had to exert a lot of intellectual work to invent the amazing recipe. This must be amortized over all meals sold, so maybe 10% of the cost. On the other hand, he might spend only 2 minutes per diner to quality-check and coordinate their specific dishes, so maybe only 2% of the cost. The dish washer might exert a lot of labor (so, maybe 5% of cost) but not much intellectual effort (1% of cost). He may use a medium level of machine labor (washing machine) (amortized as 2% of cost) and a low level of raw materials (soap and water contributing less than 1%).

Here's where I get controversial. In terms of output, clean dishes are only a small contribution to the overall "value" of dinner bill. People expect clean dishes, but they don't pay extra for extra-clean ones. They pay for the experience of good service and interesting tasty fun food. Thus, a stellar chef's contribution to the overall value is huge. He does this through inputs of his labor and intellectual R&D, possibly facilitated by some machine inputs (mixers, stoves). More investment by the chef would drive cost higher but would also support a higher price (El Bulli?). One way to think about this might be to have a line item on the menu and bill for "clean plates." How much would customers be willing to pay for this? Let's assume the restaurant gets customers to pay $36 for the fancy food and $4 for the clean plates. For simplicity, let's leave out the front-of-house (waiters, bartenders, etc.). Maybe this is a fine-dining food truck situation with just 2 workers.
  • If the dish washer and chef were paid in the idealistic communist way, they would each get 50% of the money left over after paying for raw materials, equipment, etc (aka "cost of goods sold" in accounting terms). I think most folks would struggle to support Marx at this point, but Piketty certainly tries to argue for forceful wealth distribution in order to move in this direction.
  • If they were paid in the idealistic socialist way, the dishwasher would get 40% of the money left over, based on his level of effort. This more or less aligns to the classic economic principle of "marginal price of labor capital" which has been, like all other economic theories, criticized
  • If they were paid in the idealistic capitalist way, the split would be based on labor pricing arbitrage mechanisms and efficient markets where the restaurant would post an open position notice and would seek out the best candidate who responds. Commensurately, each job-seeker would scan the job market and consider all the things they could do with their time (or other capital). The "breakeven" point between these two would determine how much each person got paid. This tends to lead to a fixed wage rather than a percentage of the revenue.
  • An alternative capitalist model might see that customers are willing to pay $4 for plates vs. $36 for food and compensate the chef and dishwasher accordingly.  
What would Piketty say, based on his worry around human labor being pushed out by machines? To explore this, let's think about machine costs in a way that is comparable with human labor. To do this, we take the initial and ongoing cost of the machine and amortize it over all products/services sold.

We can represent this graphically as follows:

Inline image 1
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This enables us to play out Piketty's concern. Imagine an entrepreneur was able to have a robot make those fancy dishes from the chef. The piecharts would change:

Inline image 7
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In our example above, the chef provided the critical intellectual and labor inputs to invent the recipe.The entrepreneur also provided intellectual and manual labor when he designed and created the robots. On a per-meal basis, the amortized fraction of those efforts is tiny if the robot makes a huge number of meals ... or is copied. While the machine has taken over the chef's per-meal labor, the dish washer still has to manually do his part.

Piketty's million-dollar question is who should get what share of the revenues? Since the dishwasher is the only one really doing manual labor, should he get all the profits? Since the chef is no longer involved in the creation of individual dishes, should he get nothing? Should the chef's paycheck now go to the owner of the robot, even though they don't lift a finger? Piketty worries that this type of shift from human (labor and analytic) effort to machine (labor and analytic) effort will mean that laborers will get a decreasing slice of the pie, while owners of computers/machines will absorb the rest. For this reason, he says wealth will pile up in the hands of "a small elite."

Bold and headline-grabbing, but pretty full of unsafe assumptions.

Capitalists might say each owner of capital (intellectual or physical or labor) should get compensated according to their contribution of that capital to the product/service which is sold. They would look to markets and pricing arbitrage to help guide the pie split. For example, If the restaurant put out a dishwasher job posting and got no responses, they'd have to increase the salary until they got enough responses. If the chef didn't feel he was well-enough compensated, he wouldn't share his recipe. And so on. This talks about HOW compensation would get determined, but it doesn't take a position on WHAT each person should get paid. Thus, capitalism is NEUTRAL on the subject that Picketty is probing. His concerns don't point out issues with capitalism. Sadly, he is confused and generally french about this point. "capitalism automatically generates arbitrary and unsustainable inequalities that radically undermine the meritocratic values on which democratic societies are based."

Fallacious logic. Nothing in capitalism forces inequalities or undermines meritocratic values.

Then he builds on this bad logic to say "because the rate of return on capital is now higher than the growth rate of the global economy, the proportion of the world's wealth that is owned by a small elite will likely keep increasing"

A couple of counterbalancing considerations:
  • As the revenue "pie" grows, there is more to spread around. So, if a dish washer used to get 5% of $100 ... and now they get 2% of $500 ... their income has actually gone up, though their percentage has gone down. Therefore his observation doesn't necessarily lead inexorably to his conclusion (or fear) of poverty-stricken laborers.
  • We should really focus on whether his "small elite" are owners of capital (Marx's fear, rewarmed) or idea creators (what happens every day in silicon valley and in every vibrant business). One really could be an ever-shrinking group of ever-more-wealthy "owners" ... the other is an opportunity available to every man. 
  • His statement about global growth and rate of return (ROR) assumes a zero-sum game where the owner's profit increase is necessarily the worker's loss. However, he doesn't prove this through data analysis. In the example above, once the robot steps onto the scene, the chef's and dishwasher's incomes likely go UP even though they don't own the robots because revenue increases 300% but the number of people sharing it only increased by 33%. There's more money to be shared. This will continue as machine automation expands. Therefore, again, even if I agree with all his observations/data, I don't necessarily come to he same conclusion
  • One way to think about it is to look at the publishing business (music, book, software, photo, etc.) where initial ideas get licensed so the creator (chef AND entrepreneur) get a slice of the profit, but so do the per-item laborers. 
In my opinion, Piketty's data simply tells us that we need to move to a "publishing" type of compensation model in more and more industries and areas. I say this recognizing that the publishing industry is in crisis, itself and is seeking better ways of operating (TIDAL, for example).

Capitalism doesn't do the greatest job of this, but it doesn't do damage either. It's answer is that the idea creator should accept bids from investors. The investor who is willing to pay the highest price should get to buy the license to use the idea. They would then put it into place (by combining the idea with financial, physical, and labor capital) and would sell the output for the highest price they can get. Labor capital would get paid for their work. Raw material suppliers would get paid for their stuff. Then the remaining profit (if any) would go to the investor. Hopefully, this profit eventually accumulates to cover the initial payment to the idea creator, after which, yes, there is a lot of profit for the investor, which over time could enable him or her to buy more and more capital, through which he or she would hope to reap more and more profits ... all while continuing to pay the laborers what they always made (or more).

Or maybe the investor does't really make more and more money as time passes. Maybe the cost of raw materials soars. Maybe someone else copies the idea and is willing to sell the product slightly cheaper. Maybe people stop liking the product. Maybe a new technology renders it obsolete and worthless. Maybe over time there are fewer and fewer laborers willing to do the work and he has to drastically increase wages to retain people. The government could shut him down or take his company. Customers could get sick and sue him. Hackers or disgruntled laborers could take all his secrets.

It's not easy. Even done right, this requires a ton of information and specifically foresight right upfront when prices are set for labor and for ideas. Since we can't really know the future, that's risky business. To encourage people to risk their hard-earned money on something like that, the potential profit margins have to be pretty awesome. The bigger the gamble, the bigger the potential has to be.

Having said that, I suspect we need to (and will) find better ways (without throwing away capitalism) to determine those prices for capital, including labor, ideas, etc. This would be a better focus of our collective attention than wringing hands and/or legislating in reaction to Piketty's soundbite.

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