Differences In Ability

In 1998, at the age of 35, Michael Jordan earned more than $50 million—$34 million playing basketball for the Chicago Bulls, and the rest for endorsing products such as Gatorade, WorldCom/MCI telephone service, and Nike shoes. Was this a compensating differential for the unpleasantness of playing professional basketball? For an unusually high risk of death on the job? Was the cost of living in Chicago hundreds of times greater than in other cities? Had Jordan, at the age of 35, spent more years honing his skills than the average attorney, doctor, architect, or engi-neer—or even more than the average basketball player?

The answer to all of these questions is no. We have overlooked the obvious explanation: Jordan is an outstanding basketball player, better than 99.999 percent of the population could ever hope to be with any amount of practice. This is partly because of his endowments—the valuable characteristics he possesses due to birth or childhood experiences but that did not require any opportunity cost on his part. In Jordan's case, these would include his natural speed, agility, and coordination. But Jordan also showed extraordinary perseverance in exploiting his talent. Together, his endowments of talent and his decision and work at exploiting them made Jordan an athlete of extraordinary ability.

While Michael Jordan may be an extreme case, the principle applies across the board. Not everyone has the intelligence needed to be a research scientist, the steady hand to be a neurosurgeon, the quick-thinking ability to be a commodities trader, the well-organized mind to be a business manager, or the talent to be an artist or a ballet dancer. This violates our imaginary-world principle that all workers have equal ability in all jobs and explains much of the wage inequality we observe in the real world.

We can understand this in terms of Figure 1 (p. 345). A wage differential between two otherwise equal jobs could persist if those working for lower wages (point A in panel (a)) cannot enter the high-wage market (point B in panel (b)) because—regard-less of how much human capital they acquire—they can never perform well enough.

Many economists believe that income inequality has worsened in the 1990s. If this is true, differences in abilities may be playing an important role. Scientific discoveries and technological advances may have increased not only the skill requirements of many jobs, but also the abilities needed to acquire those skills. (For example, greater perseverance and intelligence are needed to master a word-processing program than to learn how to type.)

But Figure 1 only tells part of the story: Wages differ not only between different types of jobs, but also within job categories. And this is largely because, in any trade or profession, workers' talent, intelligence, and physical ability—and their value to firms—vary considerably.

2 Salary figures for dentists, lawyers, and physicians are 1998 means, from the Bureau of Labor Statistics (http://www.bls.gov/oes/national/oes_prof.htm#b32000).

Although Sean Conner/s acting talent may not be a thousand times better than the average, he earns more than a thousand times the average actor's salary because he is at the top of his profession.

For example, suppose two architects have equal education and training, but architect A—being more talented—can design more innovative projects and attract twice as many high-paying clients than can architect B. Then a firm should be willing to pay architect A twice as much as architect B.

In general, those with greater talent, intelligence, or perseverance will be more productive on the job and generate more revenue for firms. Thus, firms will be willing to pay them a higher wage.

Take another look at the quote at the beginning of this chapter. Why was Disney willing to pay Sean Connery $12 million to star in The Rock? The high-ranking executive explains it: "When you plug in Connery's name, the numbers go way up." The numbers he is referring to are box office revenue, about half of which flows to Disney. In large part because of his endowments of talent and looks, Sean Connery can earn more revenue for Disney than Ed Harris can—enough revenue to justify a salary of $12 million, when Harris might have been hired for, say, $1 million.

The Economics of Superstars. Sean Connery and Michael Jordan are examples of superstars—individuals who are almost universally regarded as the best, or among the top few, in their professions. In recent years, these individuals have included model Cindy Crawford, actress Gwyneth Paltrow, attorney Johnnie Cochran, talk show host Jay Leno, and writer John Grisham. (Whatever your own feelings about any of these people, the market—where people vote with their dollars—considers them at the very top of their professions.) Still, does outstanding ability fully explain the extremely high earnings of these superstars? Let's see.

No doubt, NBC news anchor Tom Brokaw is better at delivering the news than most local news anchors. But is he better enough to justify a salary 20 or 30 times greater than the highest-paid local broadcaster? Similarly, Sean Connery is substantially better than the average actor, maybe even among the best. But is he better enough to justify a salary hundreds of times greater than the average? The same is observed among the top singers, doctors, attorneys, and so on: The additional earnings garnered by those at the very top seem out of proportion to their additional abilities. How can this be?

The explanation in all these cases is based on ability—and also by the exaggerated rewards the market bestows on those deemed the best or one of the best in a field.3 Say you like to read one mystery novel a month for entertainment. If you can choose between the best novel published that month or one that is al-most—but not quite—as good, you will naturally choose the one you think is best. Only people who read two novels each month would choose the best

It is tempting to think that jobs that require greater abilities or talents will automatically pay more than jobs that are easier and that more people can do. But this is not necessarily true. Fewer people can write good poetry than can write a good newspaper article, yet journalists earn substantially more than poets. Why? Very few people read poetry, and in that market, the derived demand for poets is very low relative to their supply. On the other hand, large numbers of people read newspapers. Compared to the market for poets, the derived demand for journalists is considerably higher relative to the supply. You will avoid much confusion if you remember that the equilibrium wage is determined by both sides of the market-supply and demand—rather than just one or the other.

3 See, for example, Robert H. Frank and Philip J. Cook, The Winner Take All Society (The Free Press: New York, 1995).

and the second best, and only those who read three will choose the top three. If most people rank recent mystery novels in the same order, then the best will sell millions of copies, the second best might sell hundreds of thousands, and the third best might sell only thousands. Even though all three novels might be very close in quality, the authors' earnings will be vastly different.

The same thing happens in the markets for rock concerts, action movies, and news broadcasts. In all these cases, where those at the top can sell their services to millions of people simultaneously, the reward for being best can be astronomical.

But this phenomenon is not limited to media stars. Suppose you needed a heart transplant, and the best surgeon is 10 percent better than the second-best surgeon. Wouldn't you be willing to pay more than a 10 percent premium to have the best, rather than the second best? The same applies to corporate executives. If Wal-Mart's chief executive officer can make decisions that are just slightly better than Kmart's, then Wal-Mart may gain significant market share over Kmart, and its earnings could be many times higher than Kmart's. This is one reason that, in the business world, small differences in perceived abilities of executives lead to huge differences in salaries.

BARRIERS TO ENTRY What Happens When

In our imaginary world, there were no barriers to entering any trade or profession. Things Change?

The absence of barriers is an important element of our assumption that the labor market is competitive. But in some labor markets, barriers keep out would-be entrants, resulting in higher wages in those markets.

In Figure 1 (p. 345), we saw that if carpenters were paid higher wages than word processors, entry into the market for carpenters would equalize wages in the two jobs. But what if carpenters were protected from competition by a barrier to entry, one that kept newcomers from becoming carpenters? Then the labor supply curve in panel (b) would not shift rightward, and the higher wage for carpenters could persist. Going back to the analogy of water flowing to equalize the water level at both ends of a pool, a barrier to entry is like a wall in the middle of the pool. It blocks the flow, allowing one end to have a higher water level than the other.

Since barriers to entry help maintain high wages for those protected by the barriers—those who already have jobs in the protected market—we should not be surprised to find that in almost all cases, it is those already employed who are responsible for erecting the barriers. But it is not enough to simply put up a sign, "Newcomers, stay out!" The pull of higher wages is a powerful force, and preventing entry requires a force at least as powerful. What keeps newcomers out of a market, thus maintaining a higher-than-competitive wage for those already working there?

In many labor markets, occupational licensing laws keep out potential entrants. Highly paid professionals such as doctors, lawyers, and dentists, as well as those who practice a trade, like barbers, beauticians, and plumbers, cannot legally sell their services without first obtaining a license. In many states you cannot even sell the service of braiding hair without a license. In order to get the license, you must complete a long course in cosmetology and pass an exam.

The American Medical Association (AMA)—a professional organization to which almost half of American physicians belong—is perhaps the strongest example of occupational licensing as a barrier to entry. The AMA portrays itself as a vigilant defender of high standards in health care, through its regulation of medical schools, its certification of specialists, and its government lobbying. Economists

FIGURE 2

Without the AMA, the labor supply and demand curves for physicians would intersect at point A to determine wage Wv AMA actions to restrict the supply of physicians have caused the supply curve to be L2, which lies to the left of L s. This implies a higher wage, W2. In addition, the AMA has sought to increase the demand for physicians' services by preventing non-physicians from competing. This shifts the demand curve to the right—to L°—further increasing the wage to W3.

THE MARKET FOR PHYSICIANS

Physicia Salarie

tend to have a much different view of the AMA. While not denying that some of its efforts do raise the quality of physicians, they see the association primarily as an instrument to maintain high incomes for doctors.

Figure 2 shows the market for physicians in the United States. In the absence of any income-raising activity, labor supply curve L J would intersect labor demand curve LD at point A, resulting in equilibrium wage W1. Whether this wage would be relatively high or low is not known; since 1847—when the AMA was founded— this competitive equilibrium has never been attained.

Much of the AMA's activity has been designed to decrease the supply of doctors. Immediately after its founding, it imposed strict licensing procedures that increased entry costs for new doctors; existing practitioners were exempted from the new requirements. In spite of these restrictions, there was a rapid increase in the number of physicians toward the end of the century. In response, between 1900 and 1920, the AMA closed down almost half of the nation's medical schools.4 These and other efforts to restrict the supply of doctors have resulted in a supply curve for physicians like L J, lying to the left of Lj, moving the equilibrium to point B, and raising salaries to W2.

But this is not the end of the story. The AMA has also increased the demand for physicians' services by preventing nonphysicians from competing. Throughout its history, the association has moved aggressively to limit competition from midwives, chiropractors, homeopathists, and other health professionals. By limiting access to these alternative health professionals, the AMA increases the demand for the services of its own members. The impact of these policies has been a rightward shift in the demand curve for doctors, to LD, moving the equilibrium to a point like C and raising salaries further, to W3.

(If you think maintaining high standards is the main motivation for these policies, consider this: AMA policy allows a physician to practice in any area of medicine, even one in which he has no specialized training. For example, a dermatologist with no training or experience in obstetrics can legally deliver a baby; a midwife

"Doctors Operate to Cut Out Competition," Business and Society Review, Summer, 1986, pp. 4-9.

with extensive experience might be arrested if she delivers a baby without the supervision of an M.D.)

In the late 1980s, rising health care costs led to increased public scrutiny of the AMA, and its anticompetitive practices came under heavy attack. Some restrictions were eased, and the number of doctors per 100,000 people increased from 169 in 1975 to 233 in 1990. At the same time, the Federal Trade Commission and the courts pressured the AMA to remove its ban on physician advertising. For the first time, new entrants could compete with established practices by advertising their prices and services. Not surprisingly, many physicians began to complain about falling incomes.

In the 1990s, physicians' advertising has intensified, and the number of physicians per 100,000 increased further, reaching 245 by 1997. Moreover, Health Maintenance Organizations have striven to decrease the demand for physicians' services by requiring prior approval for expensive tests and surgical procedures, especially those performed by specialists. And physicians' complaints have intensified.

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