Arnold Kling  

Tim Harford's Next Book

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Is called The Logic of Life. I hated the introduction. At one point, Harford writes,


Might there not be such a thing as a rational blowjob?

I don't think of myself as a prude, but I wound up muttering to myself about economists who think that sex is a good choice for a topic. Might there not be such a thing as diminishing returns and comparative advantage? I want the next pop economics book to be entitled The Undercover Economist Discovers that No More Sex Equals Safer Freakonomics.

It really was not until the fourth chapter that I started to like the book.

That chapter is about CEO pay. He explains Lazear's tournament theory this way:


The more luck is involved in work, the larger the pay gaps need to be between the winners and the losers if the tournament is to motivate anyone.

You might think, as an owner, that the more your manager's results depend on luck the less you want to reward the manager according to performance. But the problem is that if the manager's effort has little effect on performance (because it's mostly luck), then the manager only has incentive to work hard if the reward for good performance is large.

I have a very different approach to compensation. I think that the key is to change compensation schemes frequently. The reason is that any scheme can be gamed, and the longer you wait to change any given scheme, the more effectively the participants will have gamed it. That is one reason I think that "Pay for Performance," the newest miracle cure for health care costs, will fail miserably. The doctors will be able to run circles around the bureaucrats. In the U.K., they already have--all of a sudden, 91 percent of doctors were receiving bonuses for being above average.

I think that the more Washington tries to regulate CEO pay, the more it will create a disconnect between pay and performance. Regulation will inhibit companies from frequently changing their incentive systems, and that will give CEO's more time to game them.

I also really like Harford's seventh chapter, called "The World is Spiky." He describes the thinking of Robert Lucas, Ed Glaeser and others on cities. One important point is that you can meet more interesting people in a big, vibrant city. If your skills and interests are such that they can benefit from proximity to a variety of people, it is worth paying higher rent to live in a city. Conversely, if a city is dying, then the only reason to live there is to take advantage of the cheap excess housing stock.

Let me propose a subversive variation on that theory. Suppose that it really pays to be around rich people. Then as New York gets expensive, it selects richer people, and consequently it is more desirable to live there. Meanwhile, as Detroit gets poorer, it selects mostly poor people, and consequently it is less desirable to live there. This is a lot like my theory of college tuitions--the higher they go, the more that colleges wind up selecting rich people as students, and the more desirable the colleges become for people who want their kids to go to school with other affluent kids. Note that in this "segregation equilibrium" costs (rents in rich cities, tuitions in elite colleges) can rise to ridiculous levels, because the demand curves are upward sloping.

I also really liked the last two chapters, on institutional economics. I agree with much of the work that Harford cites, but not all of it. He describes the theory of Acemoglu and Robinson on endogenous democratization.


There are two players in the "game": the rich elites, who take the role of potential kidnap victim; and the poor masses, who take the role of potential kidnapper. The masses want different economic policies from the elites...If they are sufficiently indignant and are able to get themselves organized, the masses can rise up and demand greater democratic rights...new policies are not credible but new institutions might be.

I don't think much of this theory. For one thing, it assumes that the masses and the elites each homogeneous groups. It does not explain how free-rider problems are resolved within those groups.

My model of the world has multiple elites and multiple masses. The elites compete to manipulate masses. The competition tends to favor broadening the electorate. It pays to be on the side of supporting votes for women, votes for blacks, votes for 18-20 year-olds, votes for illegal immigrants...I mean, I am very pro-immigrant, but drivers' licenses for illegal immigrants? That one does not even pass the laugh test. Still, I can see where it makes sense in political terms--you expect these folks are eventually going to be given amnesty, so you want their votes.

UPDATE: The UK experience was 91 percent compliance, not 91 percent above average. But the general point still stands. The UK system paid a lot of money for what even the proponents suspect was relatively little change in actual performance, with lots of gaming (e.g., some doctors making "exceptions" of 15 percent of paitents or more).



TRACKBACKS (3 to date)
TrackBack URL: http://econlog.econlib.org/mt/mt-tb.cgi/773
The author at The Undercover Economist in a related article titled Econlog reviews The Logic of Life writes:
    Arnold Kling of Econlog did not get off to a good start with my next book:I don't think of myself as a prude, but I wound up muttering to myself about economists who think that sex is a good choice [Tracked on November 12, 2007 3:39 AM]
COMMENTS (12 to date)
Punditus Maximus writes:

Drivers' licenses for illegal immigrants make a great deal of sense in the context of 5% of the US population being illegal immigrants.

The trick is to accept that our current immigration system is a sham designed to allow efficient exploitation of Mexican nationals, rather than a rational attempt to keep borders.

Greg Ransom writes:

Illegals already get representation in Congress -- congressional districts are marked out according to overall population, including the illegal population.

And many illegals are registered to vote -- as were nine of the 9/11 hijackers.

So this has nothing to do with a future amnesty. This has to do with power in Congress right now -- and votes right now.

M. Hodak writes:

Did you know that the most successful executive compensation plan of all time remained essentially unchanged for 37 years? You can read about it (including why) here:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=816825

This doesn't counter Arnold's point that such plans in a regulatory context will inevitably be gamed into economically perverse results, but the same simply doesn't apply to CEO pay in the context of a free market. Sure, managers will quickly learn to game any system. The point is to design a system (mechanism, actually) that they can game such that the shareholders will win when management does. It's what we do.

Ajay writes:

Some counterpoints to Arnold's points:

The problem with compensation schemes is that they're often too simple and meant only to minimize work for those evaluating production and setting compensation, for example using lines of code to measure programmer productivity. What you'll find over and over again with compensation schemes that are successfully gamed is a lazy manager who didn't want to do his job so he uses some simplistic scheme to determine productivity. If one actually comes up with ways to accurately measure productivity, is willing to do the work of measurement (whether that's code reviews for programmers or performance reviews for executives), and has someone in charge who can actively penalize gaming attempts, rather than blindly following some automated system with no human oversight, compensation plans would actually work well. Those managers who do none of the above and use simplistic schemes, only to get gamed, get what they deserve. Of course, employees could always pay off the person in charge of compensation, which is the preferred trick of CEOs with compensation committees, but that is a separate issue that must be solved at a higher level and is a potential flaw for every system that doesn't address it a higher level, including Arnold's rotating compensation plan scheme.

While there is no doubt that college tuitions and city rents have spiked up over the last decade, technology has also been invented and deployed over that time period that will bring both crashing down. Today, if I want to commune with the GMU Masonomists, I don't need to move to the DC area and raise rents further, all I need to do is read their blogs and communicate with them electronically. The only aspect I'm missing is face-to-face communication over lunch but that can also be accomplished through video conferencing. As more and more people realize this and move to more affordable cities like Indianapolis or Mobile, the resulting reverse trend is going to hit big cities hard over the coming decade. The same is true of education and the coming online education boom.

As for whether it's competing elites or a homogenous elite, neither changes the point of Harford's paragraph, that there are elites who monopolize a country's resources and exclude or prey on the masses. Whether the elites compete or are united might have other effects but it doesn't change the basic fact of oligopoly.

Regarding Hodak's point about leaving compensation schemes to the market, those schemes have often been gamed like any other. Regardless of whether you let the market decide through options schemes or have internal corporate schemes, you don't change the basic fact that people are often either too dumb or too lazy to do the work required to evaluate productivity.

Taimyoboi writes:

I'd be curious to know what you think about this column by Ramesh Ponnuru.

Do you think what he describes will help to align people's health care consumption to the expected benefits associated with their consumption?

dearieme writes:

Why would it make any sense to model the determination of CEO pay as involving a contest between some body or individual who genuinely represents the interests of the shareholders, and a potential hired hand who is simply selling his labour? A better model would probably be of someone being judge in his own cause while attempting to avoid stirring up a hornet's nest.

specky writes:
M. Hodak writes:Did you know that the most successful executive compensation plan of all time remained essentially unchanged for 37 years? You can read about it (including why) here:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=816825

This doesn't counter Arnold's point that such plans in a regulatory context will inevitably be gamed into economically perverse results, but the same simply doesn't apply to CEO pay in the context of a free market. Sure, managers will quickly learn to game any system. The point is to design a system (mechanism, actually) that they can game such that the shareholders will win when management does. It's what we do.

May I observe that Mr Hodak's consultancy may also the kind of organisations hired by CEOs to design their own pay packages?

M. Hodak writes:

Ajay - I agree that most incentive schemes are poorly designed, but that's different from the accusation that they can be "gamed." Many, if not most, aspects of your life is a game. The market is, itself, a game. Those of us who design CEO incentives begin with the assumption that CEOs will try to "game" them, like you or I do in our circumstances all the time. The point is to design the game so that there is alignment of interests. A few of us, at least, do that extremely well.

Dearieme - Given my extensive experience with Boards over the last fifteen years, I can assure you that the notion that CEOs are their own judges is woefully outdated. It may have been largely true as recently as ten years ago, but today it is simply an oft-repeated myth.

specky writes:
M. Hodak writes: Dearieme - Given my extensive experience with Boards over the last fifteen years, I can assure you that the notion that CEOs are their own judges is woefully outdated. It may have been largely true as recently as ten years ago, but today it is simply an oft-repeated myth.

The oft-repeated "myth" has been proved to be real in two papers, both in well regarded journals:

Hermalin, B.E. and Weisbach, M.S. 1998. Endogenously Chosen Boards of Directors and Their Monitoring of the CEO, American Economic Review, Vol. 88, pp. 96-118.
Hermalin, B. E. and Weisbach, M.S. 2003. Boards of Directors as an Endogenous Determined Institution: A Survey of the Economic Literature, Federal Reserve Bank of New York Economic Policy Review, April, pp. 7 – 2.

Dave writes:

"The point is to design a system (mechanism, actually) that they can game such that the shareholders will win when management does"

There's significant overlap between upper management, board members and shareholders. It's not difficult to 'game' a system where a self-defined elite are designing compensation packages for each other (or in other words, themselves).

This is called a cartel.

Dave writes:

Also, I don't think it's prudish to point out that there's an unpleasant thread of mysogyny, or at least a willingness to lend credence to outdated views of women, in the current crop of 'fun' economics blogs.

The last few weeks of Freakonomics, Undercover Economist and Free Exchange have seen multiple posts on 'golddiggers', trophy wives, stereotypical behaviour in speed-dating and prostitution, so a prurient reference to the price of a blowjob does not strike me as unusual.

M. Hodak writes:

Specky, three things:

a) You can suppose that I am familiar with the deluge of literature on this subject, and two papers does not make a "proof"
b) The existence of a spectrum of relations between boards and their CEOs, which is widely granted, and the existence of a certain degree of managerial control over their boards, which is also widely granted, is not inconsistent with the notion that CEO pay is largely driven by market forces
c) What the "managerial control" and other assorted conspiracists fail to show is why CEO pay skyrocketed in the very period that everyone acknowledges that boards became far more independent and far less tolerant of mediocre management

Finally, regarding my own practice, I am not hired to set targeted compensation for executives--that's the realm of Towers Perrin, Mercer, etc. I'm hired to determine only the basis upon which that pay will vary, and there is no love lost between us and the big comp firms. So I don't have any dog in this hunt about the level of CEO pay. In fact, I would be perfectly happy to see CEOs make, say 40x, the pay of the average worker. I just wouldn't want to be in a society where this is imposed contrary to the market for talent that I personally see.

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