Contribution of the Rich to the Economy

Paul Krugman had an interesting post a couple of years ago about the claims of the rich to contribute a unique, valuable something to the economy.  (He calls it jobcreation.)  He pointed out that if we assume that the rich get paid every penny of their contribution to output, then the rich confer no net benefit on the rest of us.  All the value they create gets paid back out to them.  So causing them to work less in response to taxes won’t make the rest of us worse off.

Krugman suggests that the fact that labor gets paid its marginal product in textbook competitive markets makes the notion that the rich might get back all the value they create seem reasonable.  Maybe I’m missing something (possibly because I haven’t read the optimal tax literature that Krugman is thinking about here), but I think the rule that being paid your marginal product results in your being paid the value of your services holds only if demand is perfectly elastic.  Otherwise, the rich get their producer surplus and the rest of us get a consumer surplus.  The rich don’t get paid the full value of what they create.  And if they work less, some of the surplus to consumers disappears.  Of course, this doesn’t mean that the rest of us are net losers if the rich work less.  Krugman has a nice monopsony take on the situation that makes clear that the nonrich can come out ahead.    They lose some surplus due to reduction of production by the rich, but they make up for that by paying the rich a lot less for the output that the rich continue to contribute.

If we do away with the assumption that the rich get paid the value that they create in textbook competitive markets, then I think the wrongness of the job creators argument actually becomes clearer.  In a world in which demand is not perfectly elastic, the rich and non rich split the surplus created by the rich.   And that’s exactly what you want.  You want production to make everyone better off.  If the productive activities of the rich were to benefit only the rich, then society shouldn’t care at all about the contributions of the rich, let alone reward them.  Suppose a great entrepreneur produces a doohickey that is worth $5000 to you.  If she charges you $5000 for it, then your net gain from it is precisely zero.  You might buy the thing, but you’d have to give up so many other comforts to pay for it that your life wouldn’t actually be any better than if the thing had never been invented in the first place.  When we think of the rich as contributing to society, we’re definitely not thinking about this scenario.  We’re assuming that the rich sell what they create for less than its value, otherwise they wouldn’t be creating any value for the rest of us to speak of.

What this means is that when the rich say that they deserve more pay because they contribute more than the rest of us to society, they’re actually just asking to reduce their net contribution to society!  Herein lies the wrongness of their argument.

But doesn’t that prove too much?  Why not pay the rich nothing in order to maximize their contribution?  The answer is that what should determine pay is not the level of contribution but the cost.  To maximize the contribution of the rich to society you need to pay them the minimum amount necessary to induce them to work at a level that maximizes that contribution, which is to say, you need to pay what it costs the rich to produce at that level.  It’s cost that should matter for pay, and not contribution.

If our great entrepreneur could have made $1000 doing something other than producing the doohickey, then you’d want to pay her just enough to induce her to produce the doohickey instead — say, $1001.  You pay the entrepreneur that amount and she makes you a doohickey that you value at $5000.  The entrepreneur has contributed $3999 of value to you.  And she’s contributed $1 of value to herself (her income less her opportunity cost).  Everyone is better off.    And the entrepreneur will do the work.

There’s an additional element to the argument of the rich that I think deserves more scrutiny and criticism.  When the rich argue that they should get paid more, they tend to refer to the uniqueness of their contribution.  They have skills that no one else has.  I think that we have to understand this appeal to uniqueness to be an argument that the rich deserve monopoly power and have a right to exercise it.

Suppose that the competitive market for doohickeys results in a market price of $1001, causing our entrepreneur to control a piddly $1 of the $4000 surplus she has created through her herculean efforts.  She can live with that in the sense that it’s still enough to keep her in the market.  But she’s created so much more value for others and it just seems unfair to her not to control more of it.  What to do?  Well, she’s unique, which means that she doesn’t have to tolerate competitive pricing.  She can raise her price and not worry that you will buy from someone else at a lower price.  So she can charge $4000 or $4999 and you’ll just have to buy at that level.  And in this way our entrepreneur will end up getting what she wants, which is to be paid the full value of her contribution to society.  And, as we saw above, she will thereby eliminate her effective contribution to society.

When a CEO tells you that he deserves his high pay because no one else can fill his shoes, he’s saying that it’s just for him to use his monopoly power to extract all the surplus from the market.  And when he uses this argument to argue against having to pay more taxes, he is saying that the government should not be permitted to interfere with his monopoly power.