How Superstars’ Pay Stifles Everyone Else

How Superstars’ Pay Stifles Everyone Else

Published: December 25, 2010

This article was adapted from “The Price of Everything: Solving the Mystery of Why We Pay What We Do,” by Eduardo Porter, an editorial writer for The New York Times. The book, to be published on Jan. 4 by Portfolio, examines how pricing affects all of our choices.

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Left, Agence France-Presse; right, Pierre-Philippe Marcou/Agence France-Presse — Getty Images

In sports as in business, pay has soared at the very top of the scale. Last season, the soccer superstar Cristiano Ronaldo, right, made about 15 times as much as Pelé did in 1960, adjusted for inflation.

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Associated Press

President Franklin D. Roosevelt signed the Glass-Steagall law in the 1930s to separate commercial banking from investment banking. Standing from left are Senator Carter Glass, Senator Duncan Fletcher, Henry Morgenthau Jr. of the Treasury, Jesse Jones and Representative Henry Steagall.

IN 1990, the Kansas City Royals had the heftiest payroll in Major League Baseball: almost $24 million. A typical player for the New York Yankees, which had some of the most expensive players in the game at the time, earned less than $450,000.

Last season, the Yankees spent $206 million on players, more than five times the payroll of the Royals 20 years ago, even after accounting for inflation. The Yankees’ median salary was $5.5 million, seven times the 1990 figure, inflation-adjusted.

What is most striking is how the Yankees have outstripped the rest of the league. Two decades ago. the Royals’ payroll was about three times as big as that of the Chicago White Sox, the cheapest major-league team at the time. Last season, the Yankees spent about six times as much as the Pittsburgh Pirates, who had the most inexpensive roster.

Baseball aficionados might conclude that all of this points to some pernicious new trend in the market for top players. But this is not specific to baseball, or even to sport. Consider the market for pop music. In 1982, the top 1 percent of pop stars, in terms of pay, raked in 26 percent of concert ticket revenue. In 2003, that top percentage of stars — names like Justin Timberlake, Christina Aguilera or 50 Cent — was taking 56 percent of the concert pie.

The phenomenon is not even specific to the United States. Pelé, from Brazil, the greatest soccer player of all time, made his World Cup debut in Sweden in 1958, when he was only 17. He became an instant star, coveted by every team on the planet. By 1960, his team, Santos, reportedly paid him $150,000 a year — about $1.1 million in today’s money. But these days, that would amount to middling pay. The top-paid player of the 2009-10 season, the Portuguese forward Cristiano Ronaldo, made $17 million playing for the Spanish team Real Madrid.

Of course, the inflated rewards of performers at the very top have to do with specific changes in the underlying economics of entertainment. People have more disposable income to spend on entertainment. Corporate sponsorships, virtually non-existent in the age of Pelé, account today for a large share of performers’ income. In 2009, the highest-earning soccer player was the English midfielder David Beckham, who made $33 million from endorsements on top of a $7 million salary from the Los Angeles Galaxy and AC Milan.

But broader forces are also at play. Nearly 30 years ago, Sherwin Rosen, an economist from the University of Chicago, proposed an elegant theory to explain the general pattern. In an article entitled “The Economics of Superstars,” he argued that technological changes would allow the best performers in a given field to serve a bigger market and thus reap a greater share of its revenue. But this would also reduce the spoils available to the less gifted in the business.

The reasoning fits smoothly into the income dynamics of the music industry, which has been shaken by many technological disruptions since the 1980s. First, MTV put music on television. Then Napster took it to the Internet. Apple allowed fans to buy single songs and take them with them. Each of these breakthroughs allowed the very top acts to reach a larger fan base, and thus command a larger audience and a bigger share of concert revenue.

Superstar effects apply, too, to European soccer, which is beamed around the world on cable and satellite TV. In 2009, the top 20 soccer teams reaped revenue of 3.9 billion euros, more than 25 percent of the combined revenue of all the teams in European leagues.

Pelé was not held back by the quality of his game, but by his relatively small revenue base. He might be the greatest of all time, but few people could pay to experience his greatness. In 1958, there were about 350,000 television sets in Brazil. The first television satellite, Telstar I, wasn’t launched until July 1962, too late for his World Cup debut.

By contrast, the 2010 FIFA World Cup in South Africa, in which Ronaldo played for Portugal, was broadcast in more than 200 countries, to an aggregate audience of over 25 billion. Some 700 million people watched the final alone. Ronaldo is not better then Pelé. He makes more money because his talent is broadcast to more people.

IF one loosens slightly the role played by technological progress, Dr. Rosen’s framework also does a pretty good job explaining the evolution of executive pay. In 1977, an elite chief executive working at one of America’s top 100 companies earned about 50 times the wage of its average worker. Three decades later, the nation’s best-paid C.E.O.’s made about 1,100 times the pay of a worker on the production line.

This has separated the megarich from the merely very rich. A study of pay in the 1970s found that executives in the top 10 percent made about twice as much as those in the middle of the pack. By the early 2000s, the top suits made more than four times the pay of the executives in the middle.

Top C.E.O.’s are not pop stars. But the pay for the most sought-after executives has risen for similar reasons. As corporations have increased in size, management decisions at the top have become that much more important, measured in terms of profits or losses. Top American companies have much higher sales and profits than they did 20 years ago. Banks and funds have more assets.

With so much more at stake, it has become that much more important for companies to put at the helm the “best” executive or banker or fund manager they can find. This has set off furious competition for top managerial talent, pushing the prices of top-rated managers way above the pay of those in the tier just below them. Two economists at New York University, Xavier Gabaix and Augustin Landier, published a study in 2006 estimating that the sixfold rise in the pay of chief executives in the United States over the last quarter century or so was attributable entirely to the sixfold rise in the market size of large American companies.

And therein lies a big problem for American capitalism.

CAPITALISM relies on inequality. Like differences in other prices, pay disparities steer resources — in this case, people — to where they would be most productively employed.

Despite the great danger and cost of crossing the border illegally into the United States, hundreds of thousands of the hardest-working Mexicans are drawn by the relative prosperity they can achieve north of the border — where the average income of a Mexican-American household is more than $33,000, almost five times that of a family in Mexico.

In poor economies, fast economic growth increases inequality as some workers profit from new opportunities and others do not. The share of national income accruing to the top 1 percent of the Chinese population more than doubled from 1986 to 2003. Inequality spurs economic growth by providing incentives for people to accumulate human capital and become more productive. It pulls the best and brightest into the most lucrative lines of work, where the most profitable companies hire them.

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Yet the increasingly outsize rewards accruing to the nation’s elite clutch of superstars threaten to gum up this incentive mechanism. If only a very lucky few can aspire to a big reward, most workers are likely to conclude that it is not worth the effort to try. The odds aren’t on their side.

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Inequality has been found to turn people off. A recent experiment conducted with workers at the University of California found that those who earned less than the typical wage for their pay unit and occupation became measurably less satisfied with their jobs, and more likely to look for another one if they found out the pay of their peers. Other experiments have found that winner-take-all games tend to elicit much less player effort — and more cheating — than those in which rewards are distributed more smoothly according to performance.

Ultimately, the question is this: How much inequality is necessary? It is true that the nation grew quite fast as inequality soared over the last three decades. Since 1980, the country’s gross domestic product per person has increased about 69 percent, even as the share of income accruing to the richest 1 percent of the population jumped to 36 percent from 22 percent. But the economy grew even faster — 83 percent per capita — from 1951 to 1980, when inequality declined when measured as the share of national income going to the very top of the population.

One study concluded that each percentage-point increase in the share of national income channeled to the top 10 percent of Americans since 1960 led to an increase of 0.12 percentage points in the annual rate of economic growth — hardly an enormous boost. The cost for this tonic seems to be a drastic decline in Americans’ economic mobility. Since 1980, the weekly wage of the average worker on the factory floor has increased little more than 3 percent, after inflation.

The United States is the rich country with the most skewed income distribution. According to the Organization for Economic Cooperation and Development, the average earnings of the richest 10 percent of Americans are 16 times those for the 10 percent at the bottom of the pile. That compares with a multiple of 8 in Britain and 5 in Sweden. 

Not coincidentally, Americans are less economically mobile than people in other developed countries. There is a 42 percent chance that the son of an American man in the bottom fifth of the income distribution will be stuck in the same economic slot. The equivalent odds for a British man are 30 percent, and 25 percent for a Swede.

NONE of this even begins to account for the damage caused by the superstar dynamics that shape the pay of American bankers.

Remember the ’80s? Gordon Gekko first sashayed across the silver screen. Ivan Boesky was jailed for insider trading. Michael Milken peddled junk bonds. In 1987, financial firms amassed a little less than a fifth of the profits of all American corporations. Wall Street bonuses totaled $2.6 billion — about $15,600 for each man and woman working there.

Yet by current standards, this era of legendary greed appears like a moment of uncommon restraint. In 2007, as the financial bubble built upon the American housing market reached its peak, financial companies accounted for a full third of the profits of the nation’s private sector. Wall Street bonuses hit a record $32.9 billion, or $177,000 a worker.

Just as technology gave pop stars a bigger fan base that could buy their CDs, download their singles and snap up their concert tickets, the combination of information technology and deregulation gave bankers an unprecedented opportunity to reap huge rewards. Investors piled into the top-rated funds that generated the highest returns. Rewards flowed in abundance to the most “productive” financiers, those that took the bigger risks and generated the biggest profits.

Finance wasn’t always so richly paid. Financiers had a great time in the early decades of the 20th century: from 1909 to the mid-1930s, they typically made about 50 percent to 60 percent more than workers in other industries. But the stock market collapse of 1929 and the Great Depression changed all that. In 1934, corporate profits in the financial sector shrank to $236 million, one-eighth what they were five years earlier. Wages followed. From 1950 through about 1980, bankers and insurers made only 10 percent more than workers outside of finance, on average.

This ebb and flow of compensation mimics the waxing and waning of restrictions governing finance. A century ago, there were virtually no regulations to restrain banks’ creativity and speculative urges. They could invest where they wanted, deploy depositors’ money as they saw fit. But after the Great Depression, President Franklin D. Roosevelt set up a plethora of restrictions to avoid a repeat of the financial bubble that burst in 1929.

Interstate banking had been limited since 1927. In 1933, the Glass-Steagall Act forbade commercial banks and investment banks from getting into each other’s business — separating deposit taking and lending from playing the markets. Interest-rate ceilings were also imposed that year. The move to regulate bankers continued in 1959 under President Dwight D. Eisenhower, who forbade mixing banks with insurance companies.

Barred from applying the full extent of their wits toward maximizing their incomes, many of the nation’s best and brightest who had flocked to make money in banking left for other industries.

Then, in the 1980s, the Reagan administration unleashed a surge of deregulation. By 1999, the Glass-Steagall Act lay repealed. Banks could commingle with insurance companies at will. Ceilings on interest rates vanished. Banks could open branches anywhere. Unsurprisingly, the most highly educated returned to banking and finance. By 2005, the share of workers in the finance industry with a college education exceeded that of other industries by nearly 20 percentage points. By 2006, pay in the financial sector was again 70 percent higher than wages elsewhere in the private sector. A third of the 2009 Princeton graduates who got jobs after graduation went into finance; 6.3 percent took jobs in government.

Then the financial industry blew up, taking out a good chunk of the world economy.

Finance will not be tamed by tweaking the way bankers are paid. But bankers’ pay could be structured to discourage wanton risk taking. Similarly, superstar effects are not the sole cause of the stagnant incomes of regular Joes. But the piling of rewards on our superstars is encouraging a race to the top that, if left unabated, could leave very little to strive for in its wake.