Could we have both a free and a fair market?

entropy by TroyMason
‘Econophysics’ points way to fair salaries in free market
[Via Eureka! Science News]

A Purdue University researcher has used “econophysics” to show that under ideal circumstances free markets promote fair salaries for workers and do not support CEO compensation practices common today. The research presents a new perspective on 18th century economist Adam Smith’s concept that an “invisible hand” drives a free market economy to a collective good.

“It is generally believed that the free market cares only about efficiency and not fairness. However, my theory shows that even though companies focus primarily on making profits and individuals are only looking out for themselves, the collective self-organizing free market dynamics, under ideal conditions, leads to fairness as an emergent property,” said Venkat Venkatasubramanian, a professor of chemical engineering. “In reality, the self-correcting free market mechanisms have broken down for CEOs and other top executives in the market, but they seem to be working fine for the remaining 95 percent of employees.”

[More]

Not being an expert in entropy, statistical thermodynamics or economics, I am not at a place to determine whether this guy’s theory is correct or not. At least not the math (I used to be since understanding thermodynamics of biological systems uses a lot of similar math). But it does seem ‘right.’

I do like the the PR provides a link to the paper and that it is Open Access. Perhaps I will have a chance to understand it in detail. I do find it interesting that his model predicts ‘fairness’ in a free economy by utilizing the principle of entropy.

The key here is the previous models do not say much about fairness in an efficient free market. His model produces fairness in salaries as an emergent property of a free market. HIs first paragraph is a really interesting question:

The excessive compensation packages of CEOs of U.S. corporations in recent years have brought to the foreground the issue of fairness in economics. The typical response to the question “What is fair pay for a CEO?” is that whatever the free market for labor, driven by the forces of supply and demand, determines it to be. The conventional wisdom, however, is that the free market cares only about efficiency and not fairness. Is this view correct? This is the question we examine in this paper.

There are some novel consequences of his model, which makes the simplifying assumptions that in an ideal free market, workers are free to move to any other employment that offers them better conditions. They can do this because their is also no impediment for information flow about salaries between all the employees in the marketplace.

So, easy movement between jobs based on a total knowledge of salaries. If this is possible, then a fair salary market appears – fair meaning that one’s salary is actually commensurate with one’s contribution. As he states:

Even though an individual employee cares only about his or her utility (salary) and no one else’s, the collective actions of all the employees, combined with the profit maximizing survival actions of all the companies, in an ideal free market environment of supply and demand for talent, under budgetary constraints, lead towards a more fair allocation of wages, guided by Adam Smith’s invisible hand of self-organization.

I may not understand all the math but the underlying principles make sense. A company wants to minimize salaries while individual employees want to be paid commensurate with their work, if not more. So employees will leave poorly paid positions for better paying ones. The feedback loops between companies and employees push salaries around. Eventually, at equilibrium, things settle down to a ‘fair’ level.

One result from his model is that anything that prevents employees from freely moving to other employment opportunities will hamper the emergence of a fair market. An example in America would be the large number of people who really can not move because of healthcare costs, which are not included in salary. Allowing people to retain effective healthcare even as they change employment would result in a fairer economy, as I understand this model.

Also, mobility between companies must be high in order for this fairness to emerge. If people are afraid of employment, such as during something like the Great Recession we are in, then unfairness can increase tremendously as there is no longer any negative pressure on companies to mistreat employees. Their salaries become more unfair.

Finally, not knowing what others are making hampers a fair free market. This has been overcome somewhat in recent years because the internet helps provide this information at a much higher rate than before, but I would expect that it is still not as efficient as it should be.

This is actually a fascinating paper. I especially appreciate the heading of one section Essence of Entropy is Fairness – at the end state, when everything has reached equilibrium and no further changes are made, the economy is then inherently fair and everyone is being paid exactly according to their contribution.

So, just as the Heat Death of the Universe appears when maximum entropy is reached, so too is a free and fair market. HIs model suggests that striving for maximum entropy in a free market will more likely produce a fair market.

We believe that by recognizing entropy as really a measure of fairness, which is a fundamental economic principle, and showing how it is naturally and intimately connected to the free market economic environment, our theory makes a significant conceptual advance in revealing the deep connections between statistical thermodynamics, information theory, and economics.

Hope it is true.

His work indicates that, while the free market seems to work to provide fair salaries for employees, we are not seeing the same thing with the salaries of CEOs. They are making up to 130 times what they should be making under a fair and free economy.

By his model, CEOs are abusing the fairness of a free economy. Something I think we can all agree with. Just nice to see a theory that demonstrates this.

Now if his model could only tell us how to correct this. It makes some very important simplifying proposals that may be very hard to actually implement in a real world. Perhaps, if it really is a robust theory, we could use it to accurately determine what the salaries should be.

However, I think that either by theory or commonsense, the salaries of CEOs must be brought back under control and placed much closer to the levels that they used to – and, by this model, should occupy.