A couple of weeks ago, news broke that Wal-Mart CEO Michael Duke makes more in one hour than a new Wal-Mart employee makes in a whole year. In other words, he's making more than 2000 times what the lowest paid employee is making.
Most of us have a "gut feel" that most American business top-executives are paid too much: in many cases, hundreds of times more than the lowest-paid employee of their companies, and in some cases (like Wal-Mart) thousands of times more. And that's much higher than comparable executives at non-American companies, too.
New research from Purdue University now shows that this gut feel correct: there is only one form of pay distribution that can be generated by an ideal free market – the market guided by Adam Smith's "invisible hand", the market allegedly held in high esteem by CEO's themselves – and that distribution is the fairest distribution of pay. And, while 95% of American workers fall within this fairest, market-driven pay distribution, top executives do not.
While Michael Duke may be the most egregious example, even in the non-profit sector, a new study has shown that some hospitalsin California spend more on their CEO than on all of their charity work.
In a previous diary, I reported on the interesting work of Dr. Venkat Venkatasubramanian, a physical chemist at Purdue University. In his earlier 2009 paper, he speculated (on the basis of monetary theory) that the fairest pay distribution for a company would be the lognormal distribution (see figure at right). It's important to note that for about 95% of wage earners, the income distribution does indeed follow a lognormal distribution. (Care to guess which 5% don't follow the lognormal distribution? It's the top earners, who in many large companies earn dozens or even a hundred times more than the lognormal distribution indicates.)
Now don't get me wrong. The lognormal distribution doesn't imply everybody gets paid the same. It's not some socialistic pie-in-the-sky plot. Far from it. Under a lognormal distribution, the most talented employees get paid more, and in fact a lot more, than the lowest skilled. But they don't get paid obscenely more, as is the current situation in American business.
In his latest paper, Dr. Venkatasubramanian has extended the theoretical basis of his earlier work, and showed that in an ideal free labor market, with many companies and many employees, the distribution of salaries among employees will naturally move toward a lognormal distribution in any company. Further, since such a distribution is the natural outcome of an ideal free market, it also must be the fairest distribution. In other words, it assumes that all players in the labor market, both companies and employees, have access to all information about the market. Everybody knows what everybody earns; every employee is free to change companies at any time to get a better salary; and every company is free to pay their employees less in order for the company to earn more.
As an important corollary to all this, Dr. Venkatasubramanian also shows that the math underlying this distribution is identical to the math used to compute entropy. In effect, the physical concept of entropy – often equated with "randomness" or "decay" in physical systems, or with "uncertainty" in information theory – is, in economic terms, the same as fairness: a condition of maximal stability.
This has some pretty deep implications, which perhaps even he is not aware of. First, if we really want a market that is both free and fair, everybody should know what everybody else is making. Somewhat counterintuitively, currently such information is available only for highly paid executives of public companies – the same people whose salaries do not follow the ideal free-market lognormal distribution.
The other implication is that companies actually can lower executive pay and still retain their highly-skilled employees. In fact, using this work, the compensation committee of any company board would have an easy-to-follow guide which can show them pretty clearly how much a CEO (or any other pay grade, for that matter) should be compensated, based on the total amount of money the company has available for compensation. In fact, the lognormal distribution can even be used as a guide for determining how bonuses can be fairly distributed to a company's employees. (Hint: it's not only executives who should get bonuses.)
Links:
Dr. V.'s 2010 paper:
News Release
Abstract
Full Paper (pdf, 718k) Entropy 2010, 12(6), 1514-1531; doi:10.3390/e12061514
Dr. V's 2009 paper:
News article.
Abstract.
Full Paper (pdf, 222k) Entropy 2009, 11(4), 766-781; doi:10.3390/e11040766.