Supply AND Demand, not Supply or Demand

If you think hedge fund managers or lawyers earn "too much money," one possible solution is to argue for MORE hedge fund managers or lawyers. Sound counter-intuitive? It doesn't if you follow the logic of supply and demand.

One of the basic principles of economics is that both supply and demand determine prices and quantity exchanged. It doesn't matter how many mud pies I produce, if no one wants them, the price is zero. Similarly, if only one dude in Scotland makes the whisky I love, I'll have to pay more than I would for Seagrams.

I thought of this basic insight when I saw multiple tweets on my feed about the difference between the top hedge fund managers' earnings and kindergarten teachers. The most frequent source was a article from Matt Yglesias.

The news once again is that it's good to be a successful hedge fund manager: the top 25 earned a collective $21.1 billion this year...

How does that look in context? Well, it's about 0.13 percent of total national income for 2013 being earned by something like 0.00000008 percent of the American population. Another way of looking at it is that this is about 2.5 times the income of every kindergarten teacher in the country combined. (links in original)

Knowing much of Matt's writing makes it hard for me not to read into what he is trying to say. In another post, he is more clear of his opinion. Here, however, I will try to deal with the above quote at face value. Presented with this information, what can we learn?

Less than you think. Prices reflect complex phenomena and the interactions of millions of people. Our instinct might be nausea over "unfairness." However, this stat tells us little about the underlying mechanism that caused it. It tells us nothing of "fairness," "right," or "justice."

Earnings, wages, returns, salaries, or whatever you want to call them are just prices, like many other things. Yes, we might consider them extremely important prices in our own lives, but they are subject to the basic laws of price theory that governs the trading of apples. Supply and demand work together to coordinate people's plans. This is a very good thing. I've had a earlier post arguing such.

If prices passed some moral judgement (which they don't, they just exist), I  should hear people who are worried about the excessive wages of hedge fund managers arguing for MORE hedge fund managers. This would drive down the wage of those already in that job. I don't hear this. I only hear about "unfair" salaries.

Diamond/Water Paradox Redux

People's wages do not come from an underlying true value.  Instead, this price comes from millions of people interacting. Prices are complex phenomena that emerge from people's choices. It is the marginal interaction that ultimately determines their value. The comparison between the wages of hedge fund managers and teachers is like comparing the prices of diamonds and water.

Diamonds are more expensive because of the low supply. What does low mean? I don't know. Since there are only a few diamonds available, the next unit is valuable. I don't know about you, but I don't have any diamonds. Diamonds are cool and I would be willing to pay a few bucks for one.

Water is different. Obviously, water is more important in many ways. However, water is cheap, because it is more abundant, at least to people in developed countries. I don't pay much for water. I have a bunch. I don't value the next glass of water.

This valuation of the next unit determines the prices. Remember, all decisions are on the margin based on people's valuation of the good. The price does not come from a true or ultimate value of "water" vs "diamonds."

I'm glad for teachers.

The same reasoning applies to hedge funds vs. teachers. Their wages arise from marginal valuations of other people in the market.  Luckily, there are many people willing and able to be teachers. That is a great thing. Few people are willing and able to be hedge fund managers. That's okay.

Could you imagine if we had to have as few teachers as we have hedge fund managers? That would be devastating. I'm so grateful that we have more teachers. I wish they could get paid more, but I wish everyone could. People live in a world of scarcity and we can't have everything we want. The interactions of people on a market, which we can understand through the model of supply and demand, help coordinate plans to make people better off under this scarcity.

If I'm still not making sense, Anthony Carilli has a great intro lecture of supply and demand. He even has insights for people who have seen the graph a million times.

Prices just reflect underlying conditions. There might be problems with the underlying system, but prices cannot tell us that.

One Question

While price theory is well established, that does not mean that I know every aspect of it. While writing, I thought of a puzzle. It's not a puzzle of price theory, proper, but a puzzle about its practitioners.

When a disaster strikes, believers in the free-market applaud the increase in prices of goods. These prices create an incentive for people to supply more of whatever good.

To my knowledge, these same people do not applaud high wages in finance as incentive for more hedge fund managers. What am I missing?

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