Why Are You Paid So Much?

The public reaction to hearing about a banker’s bonus or a sportsman’s contract is part envy and part disbelieve. Why should they be paid hundreds of time more than me? Some call for salary caps and high tax rates to stop them earning so much.

Adam Smith identified many of the reasons behind why some people are paid more than others. This was almost 300 years ago, yet they still apply today. So lets examine them.

Productivity

Some people are skilled at a particular task. It may take me half an hour to fix a leaking tap, whereas a plumber can do the job in five minutes. So it would be entirely fair for the plumber to charge a higher hourly rate. If the task was pruning a tree, however, I will be more productive than a plumber. Once you find a job you are good at, you will be able to earn a higher wage.

The other aspect is scalability. Even the best plumber may only ever be able to fix a few thousand taps a year. If they want to make more they need to make their labour scalable. For example, if he could film one repair and sell millions of copies of a ‘how to fix a tap’ DVD.

Management

A manager is a person who supervises other people. In order to reward their management skills, they should earn a portion of their employees pay. This way, if an employee becomes more productive both the employee and the manager get a pay rise. As you work your way up the pyramid the pay increases.

Opportunity Cost

Lots of people dream of becoming a pop stars, footballers, lawyers, etc. Unfortunately, there is only a limited number of places available. To get one of these places you need to practice and study to prove you are the best. Unless you are rewarded with a higher wage you would not bother making this investment.

If only one in ten thousand golfers are able to turn professional. Then a professional golfer should earn ten thousand times more than the opportunity cost, ie, alternative wages, training, equipment costs etc. Otherwise no-one would bother taking the risk.

Profit

Not all income comes from labour. Interest, dividends, royalties, and rent also produce income. An entrepreneur who owns and manages a business may take a portion of the the profit in the form of wage or bonus. Even though in economic sense it is a return on their investment.

Unfortunately, some people try to expand this idea to other employees to make them think like an entrepreneur. But it only works if the employee has a sizeable investment, so there is a downside if the company makes a loss.

Negotiation

Measuring productivity is very difficult especially when a task requires teamwork. So the actual wage comes down to negotiation skills. The wage will be somewhere between the employer’s perceived value from the job and the employee’s next best job offer.