Saturday, May 28, 2005

The Economics of Superstars

Interesting article on the economics of superstars by Sherwin Rosen, a professor economics at the University of Chicago.

In the article, Rosen discusses the excessive salaries paid to titans in industries such as entertainment, sports and business.

He examines:

"The phenomenon of superstars, wherein relatively small numbers of people earn enormous amounts of money and seem to dominate the fields in which they are engaged. "

Yet the thing about these superstars is that they are not 10x as talented as the tier below them, however, they are paid more than 10x as much. Why is this the case?

"If one surgeon is 10 percent more successful in saving lives than another, who among us would not be willing to pay much more than a 10 percent premium to have the more skillful person perform the operation?"

Compare this to farming, where "two persons who harvest half as much are about as good as one whose productivity is twice as large. " Unfortunately, two surgeons who are half as talented as one superior surgeon are not equivalent to the one surgeon.

" More capable physicians spend smaller fractions of their time on routine cases and larger fractions on difficult ones than do physicians of more modest ability, and it is socially desirable that they should do so. "

(As aside, couldn't you argue that by allowing the more capable physicians to spend more time on difficult cases, they further develop their skills and become even more capable? This occurs as less capable physicians are relegated to routine cases and thus left to stagnate and remain at the same lesser level of ability.)

Another example is the exorbitant pay of executives of companies-- often the pay of executives at the top are more than 100x the pay of those at the bottom (think Eisner and Disney). Is this justifiable?

Rosen argues that it is:

"The value to the organization of good top-level decisions and avoidance of bad decisions is abundantly clear once the nature of control of resources on such a vast scale is considered."

Take for instance the military (business is often likened to war):

"A good or bad decision by a platoon leader does not have much effect on the overall fortunes of war, but the same cannot be said of decisions made by the chief strategists. The value of extra talent is much larger at the top of the organizational hierarchy than at the bottom because those decisions percolate through the enterprise, and they have much further to travel in a larger enterprise than in a smaller one."

How true this is -- the decision of a small group at the top of an organization will trickle down and impact those spread throughout the organization.. for example, Bill Gates recently commented, "“If I write a comment that says, ‘We should do this,’ things will be re-orged, engineers will move. It’s not like I can just read this paper and say, ‘Hey, cool, looks good.’ They’ll assign 20 people to it then.”

Rosen then moves on and meanders into a discussion of the scaling abilities of content producers -- answering the question of why Tiger Woods should earn vast multiples over a mere golf caddy:

"The performer or author puts out more or less the same effort whether one thousand or one million people show up to listen to the concert or buy the book... "

This is the advantage of content driven businesses... however,

"Most economic activities are far more constrained in this respect. In the generality of such activities, costs increase more nearly in proportion, or more than in proportion, with output. When this is the case, it is not necessarily advantageous to work on the grand scale... Services rendered by most professionals and other workers require significant one-to-one contact with buyers, and each of these contacts takes time... Here it becomes clear that technologies that enable sellers to cater to mass audiences account for the small number of successful practitioners in the fields we commonly associate with superstars...

"Once again a little extra ability goes a long way. The return on each unit sold may be very small, but total reward is enormous because unit reward is multiplied by a large number. "

Thus the compensation of those with just an inch more of ability is magnified by the leveraging of scale and law of diminishing costs.

"Dilution of a large talent maintains competitive advantage over smaller talent if the price is right.

"Whatever the sources of these differences, economics of the scale afforded by modern media imply that it is monetarily more advantageous to operate in a larger overall market, and it is increasingly advantageous the more talented one is. "

This could be one explanation for the dominance of U.S. entertainment throughout the world.

Rosen continues:

"Is all this fair? Probably not, few people grow to be seven feet tall, never mind with the agility of a cat. Fair or not, it is the necessary and natural outcome of the unusual technology with which we now live. "

Life is not fair -- deal with it.

For more info, check out an assessment of superstar economics from Stumbling and Mumbling.

(BTW, would you be shocked if you learned that Rosen wrote this article in 1983? Surprisingly enough, the things Rosen observed over 20 years ago are still VERY true today.)