Tuesday 18, April 2023

Adam Smith divided value into wages, profits and rent. Rent was the income derived from that factor of production whose supply was perfectly inelastic, the return to the rentier, which comprises an income derived from the scarcity of land, of which there is a fixed amount in the world.

Profits are the income which derives from the use of capital, such as a ship or a factory. Capital can be produced, but at the cost of (current) consumption. So, profits are the reward for deferred consumption.

Wages are the return to labour. In some sense, labour is like capital: people even speak of ‘human capital’, but the supply of it does not respond to the price in the same way that physical capital does.

Economics is a complex subject, and I am not an economist, but I wanted to state a few definitions, rather than just dive in and use jargon words which have meanings which are different to those used in ordinary English.

Keynes tended to write about labour as a homogenous resource. He did make some acknowledgement of some workers being able to command a higher wage than others, but he implicitly (maybe explicitly: it’s a long time since I read ‘The General Theory’) hand-waved that away, saying that as long as the relative wages, and the relative proportions of workers with the various skills, remained constant, this did not invalidate his theory.

The idea that variations in individual wages are just a reflection of the variations in individual productivity seems utterly at odds with what I have observed in my working life, and with what I see in the world around me. For it to be true, it would need a perfect market in which the value of an individual to his employer would be instantly measurable. In the real world, employees become valuable only after a considerable time with their employers. There is a lot of job-specific knowledge to absorb. Job switching has a large cost for employee and employer, something that is (partially) reflected in the many laws which treat a contract of employment very differently to a contract for the supply of potatoes.

I think it’s clear that a high cognitive ability is a requirement to do quite a few jobs. Top lawyers are, I am sure, very smart. But surely, their remuneration is more a function of their scarcity value than of some intrinsic productivity. This all meshes with the signalling value of education. The salary boost of having gone to Harvard Law School is surely not a function of the actual knowledge obtained there, but of the credential of having been admitted to it.

The only problem is how to demonstrate this as the explanation, as opposed to the idea that the reason investment bankers are paid so much is that there is such a high demand for them, relative to supply. This seems really very unlikely, but might be true. Some observers have pointed out that the demand for lawyers is largely a function of how many lawyers are already practicising.