What’s fair?

In the comments of this post, Wally posted a video about how actual wealth distribution differs from what a group of people feel like is the ‘ideal’ wealth distribution.

I think the video provides a good example of the dangers of convoluted reasoning disguised as something that sounds intelligent.

For instance, in one part of the video, the narrator says that CEOs make as much in one hour as their average employees make in a month and suggests that is unfair.

When framed this way, the unfairness seems plausible. However, this framing is like a distraction used in a parlor trick, or a red herring.

He implies that a CEO should make some multiple of the wages of an average worker, but he doesn’t tell you why. He figures you get it. But, do you?

Most of the average workers who have young children make several orders of magnitude more than those children.Is that fair? People with kids may now realize the distraction.

It’s not a question of fairness. They understand that there isn’t necessarily a relation between what they make and what their children make. They understand that what they make is based on the value they create for their employers or client and what others are willing to do that for, as well.

Now, don’t get me wrong. I think most CEOs are overpaid. But, I don’t base that opinion on nonlogic like what I think a fair multiple is between some unrelated job and their job, no more than I think what a nurse is paid should be some multiple of what a painter makes, or what a professional baseball makes should be some multiple of what the beer vendor in the stands makes. That’s nonsense.

I think most CEOs are overpaid in part because their decisions do not increase the value of their company enough to cover the risks they take and because Boards of Directors aren’t interested enough to get find truly good business leaders.

The whole video is a red herring. It basically compares ‘an ideal’ wealth distribution to the actual wealth distribution and implies that something is unfair. But, it takes more than a red herring to convince this guy.

Try to use some logic. Let’s talk about the value the people at the low, middle and high ends of the distribution create. Let’s talk about their financial behavior, their investments in human capital, decisions they’ve made.

Let’s talk about the absolute wealth at each end. Should I care than Bill Gates doesn’t fit on his chart, if I’m living a life unimaginable by my even fairly recent ancestors?

Update: ‘Dude Where’s My Freedom”s comment reminded me of the lyrics from Tenacious D’s song, City Hall. After starting riots to overthrow government and now ruling, Jack Black and KG are issuing their decrees. Their third decree is,

No more rich people and poor people. From now on, we’ll all be the same…ummm…I don’t…I gotta think about that.

Funny and true.

A Lesson in Supply and Demand

In his column today, Economic Whodunit, Thomas Sowell provides a great example of using supply and demand to explain things.   Here, he uses supply and demand to explain the behavior of housing prices.

But an increased demand for housing does not automatically mean higher housing prices. In places where supply is free to rise to meet demand, such as Manhattan in the 1950s or Las Vegas in the 1980s, increased demand simply led to more housing units being built, without an increase in real prices– that is, money prices adjusted for inflation.

What led to a boom in housing prices was increased demand in places where supply was artificially restricted. Coastal California was the largest of these places where severe legal restrictions on building houses led to skyrocketing housing prices. Just between 2000 and 2005, for example, home prices more than doubled in Los Angeles and San Diego, in response to rising demand in places where supply was not allowed to rise to meet it.

Lessons in supply and demand are good, because I think there are widely held misconceptions about what ‘supply and demand’ is.

Two examples:

  • A few nights ago, a friend of a friend wrote on a Facebook comment that the ‘laws of supply and demand do not apply to commodities because these are controlled by speculators”.
  • Someone in my family often tells me that ‘supply and demand doesn’t work because prices of cars keep going up.”

In both of these cases, I think the owners of these comments believe that ‘supply and demand’ means that prices will always go down or be favorable in some sense.  This is not a correct view of supply and demand.

Supply and demand governs price behavior and you can use what we know about supply and demand to explain what caused changes in price levels and what might happen in the future.  Whether you’re talking about the price of a stock, education, health care, cars or commodities – the laws of supply and demand apply.

Sowell continues:

The problem was that, not only were these mortgages based on housing prices inflated by the Federal Reserve’s low-interest rate policies, many of the home buyers had been granted mortgages under federal government pressures on lenders to lend to people who would not ordinarily qualify, whether because of low income, bad credit history or other factors likely to make them bigger credit risks.

This was not something that federal regulatory agencies permitted. It was something that federal regulatory agencies– under pressure from politicians– pressured and threatened lenders into doing in the name of “affordable housing.”

To sum up, housing prices in some areas were on the rise because demand was increasing due to low interest rates and a Federal government goal to get people into the house buying market that were not there before – poor credit risks.  At the same time as demand was increasing local building restrictions in some areas limited supply.  Increase demand without changing supply and rising prices result.

When the poor credit risks to the expected – stop paying their mortgages and try to get out of the homes they can’t afford, that puts more supply on the market while demand is shrinking because higher interest rates make it less affordable for people to purchase homes.  Increasing supply and decreasing demand leads to price drops.