David Henderson on Robert Frank

David Henderson, editor of the indispensable Concise Encyclopedia of Economics, takes on Robert Frank’s idea that the modern American economy is infected with toxic levels of "keeping-up-with-the-Joneses."  Here an excerpt from David’s Cato Policy Report essay:

A pillar of Frank’s argument is that a
large percentage of people care about their
relative position. In Choosing the Right Pond,
he defends that assumption by pointing to
anomalies in the pay structure of various
firms, anomalies that he attributes to
people caring about relative position. Most
of his anomalies have to do with pay
structures that, Frank argues, are "flatter"
than standard economics would predict.
Standard economics states that workers
are paid an amount roughly equal to the
value of their marginal product–that is,
the increment in value that is due to their
being in the firm. But, notes Frank, if this
were true, one would expect to see great disparities
between the salaries of workers
who have great differences in productivity.
He points to, among other things, the
University of Michigan pay scale for economists
in 1983-84, where the highest salary
was only a little more than double the lowest.
He never mentions the fact that the
University of Michigan is a government
bureaucracy, making it not the best test of
the standard economics account of freemarket
wages. Nor does he mention that
one of the main ways the stars of academic
institutions are "paid" is with lower teaching
loads and more research funds.

Even more interesting is how the world
seems to have changed since Frank began
writing about these issues and the contortions
he goes through to sustain his argument
for higher taxes. When he first began,
he argued that relatively flat pay structures
are indirect evidence for his view that people
care a lot about relative position. But in
his May 2007 testimony, Frank noted that
the "anti-raiding norms of business have
recently begun to unravel" so that, now,
pay for top managers can be a huge multiple
of pay for bottom managers. In other
words, it would seem, many top managers
are being paid an amount that approximates
their marginal product. You might
think that this would cause Frank to reexamine his earlier strongly held views. But
he doesn’t.

Instead, he comes up with a new argument
for progressive consumption taxes.
He now argues that too many people are
vying for the top jobs because of the higher
pay those jobs carry. They are fighting, he
argues, over a fixed pie and, in a variant of
the famous "tragedy of the commons," he
compares the competition for the top jobs
to gold prospecting. He testified that "the
gold found by a newcomer to a crowded
gold field is largely gold that would otherwise
have been found by others." Similarly,
he argues, "an increase in the number of
aspiring hedge fund managers produces
much less than a proportional increase in
the amount of commissions on managed
investments."

But he can’t hold on to this argument
for even a page. Just four paragraphs later,
he testified: "A slightly more talented CEO
or hedge fund manager can boost a large
organization’s annual bottom line by hundreds
of millions of dollars or more."
Exactly. It does make sense, therefore, for
companies to look for small differences in
talent because those differences can cause
huge increases in profits. The problem
with Frank’s tragedy of the commons analogy
is that there is no commons. The
tragedy of the commons occurs when no
one owns the resource: thus the word
"commons." But those who hire hedgefund
managers own their resources, so one
would not expect overinvestment in being
the manager. Frank implicitly admits this,
writing, "To be sure, even those who fail to
win the biggest prizes often go on to earn
comfortable incomes." But in the very next
sentence, he retreats to his old position,
saying, "But career choices must be measured
not in terms of absolute pay but relative
to what might have been" (emphasis
added). This is astounding. More than 20
years ago, Frank argued, as an empirical
matter, that people care about relative
income. Now in the face of evidence that
absolute income matters a lot to them–
otherwise, why would anti-raiding norms
have unraveled–he argues that it shouldn’t–
thus his use of the word "must." If the
people don’t conform to his assumptions,
it seems, we should tell them to.

Here is Bob Frank’s webpage.

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