Friday, December 04, 2009

The Grand Game!

It's been a while since we played "The Grand Game." That's where KPC readers are referred to a remarkably idiotic piece of writing, and invited to go medieval on its ass. Here is this week's fresh meat:

What is Fair Pay for Executives? An Information Theoretic Analysis of Wage Distributions

Venkat Venkatasubramanian, Entropy, December 2009, Pages 766-781

Abstract: The high pay packages of U.S. CEOs have raised serious concerns about what would constitute a fair pay. Since the present economic models do not adequately address this fundamental question, we propose a new theory based on statistical mechanics and information theory. We use the principle of maximum entropy to show that the maximally fair pay distribution is lognormal under ideal conditions. This prediction is in agreement with observed data for the bottom 90%–95% of the working population. The theory estimates that the top 35 U.S. CEOs were overpaid by about 129 times their ideal salaries in 2008. We also provide an insight of entropy as a measure of fairness, which is maximized at equilibrium, in an economic system.


Me, I just enjoy saying "Venkatasubramanian." But: Wait! There's more. Here's an article about Venkat Venkata's work, here. An excerpt:

As a professor of chemical engineering at Purdue University, Indiana, Venkatasubramanian seems an unlikely candidate to dictate CEO salaries. It turns out that the maths behind thermodynamics, the study of heat and energy, can also be applied to economics.

Discuss!

(Nod to Kevin L, who is according to maximum entropy is underpaid by 130%)

15 comments:

John said...

Hmmm, okay, here's one problem with this paper. Taking a theory that is valid in a hard science and applying it to a soft science may not make sense. Gravity states that what goes up must come down. Applying that to Gov't budgets doesn't seem to work.

The statement "According to the laws of supply and demand, as markets evolve salaries and the price of goods should move towards the most fair situation for everybody." is a misreading of econ 101. Supply and demand show that as demand rises, or supply contracts, price will raise. Management talent is in ever greater demand, ergo salaries rise.

Cherry picking 35 CEO's out of the Fortune 500 list seems a lot like data manipulation. Why not the whole data set? Seems kind of like global warming data.

Defining salary as solely the money paid in one year directly is wrong as well. Executive compensation includes vastly more pieces, such as stock options/grants, deferred comp, perks, etc. These should have part of the analysis.

The statement that execs at startups are worth far more relative to their few employees than are heads of large corporations is nonsensical as well. If anything, the employees at startups should be paid higher relative to their CEO as their duties will be more extensive, their job security lower, and their value to the organization less diffuse than if they were one among a sea of faceless employees.

How's those critiques for a start?

Kunal said...

It turns out that the maths behind thermodynamics, the study of heat and energy, can also be applied to economics.

OMG, that is an awesome idea! We should totally apply that to, eg option pricing!

Mark Bonica said...

I'm with Kunal. With this kind of deterministic approach we can start a hedge fund and make lots of money. I even have a name for it - we can call it "Long Term Capital". I'm pretty sure it's available.

"Fair" is only relevent when you are using coercion to determine an outcome. And then it's inherently not subject to being modeled - unless you are measuring the size of the sticks used by the enforcers.

Anonymous said...

Value is subjective, you maths-loving commie.

Anonymous said...

How do thermodynamics equations describe "fairness"? What about energy flow through chaotic systems of particles can possibly tell us about fairness?

Fairness is subjective.

Anonymous said...

-Ditto to subjective value

-To determine a mathematical standard for "fair," there must be an universal standard of fair. As far as one does not exist, it will apply to the equation writers value judgment. The wage earner considers it fair when his wage goes up and unfair when his wage goes down; the seller sees it as fair when his price goes up and unfair when it goes down. Is it unfair that the businessmen and wage earners in the telegraph industry saw there earnings drop when they did not adjust to the market data initiated through a switch in consumer's demand to the telephone industry? If so, should we then have punished the telephone industry (for a modern analogy see: newspapers)?
If Aquinas had achieved his concept of a "just price" then 13th century conditions would still prevail.
--The apparatus most efficient in creating artificial prices and wages through compulsion and coercion is government. Then we must wonder why it is the most hampered industries which require the most "maintenance" from the interventionists.
-sean

Andrew Stella said...

Wow...

I'm planning becoming a chemical engineer...

If I ever become that detached from reality, please, someone smack me over the head with a copy of Atlas Shrugged. Thanks.

Michael said...

This just pushed the "corporations follow the behavior of a psychopath"" argument off the crazy mantle.

Schepp said...

Seems the reaction is a little to strong. While applying thermodynamics to fair CEO pay is crazy, I think there is much to gain from testing if math and science from one field can be apply to another.

I would want our government to come to come to the conclusion that for every payment there is an equal and opposite payer. Parallel to Newtons 3rd law of motion: "For every force there is any equal and opposite force."

That does not imply that there are not efficiencies or friction issues that can be found to improve the market.

Tom said...

"Fair" is too squishy a concept to even qualify as subjective. Economists may as well ask what does statistical mechanics say about a fair color for BMWs? Stop laughing -- color-of-car is an important question that people spend time and money on.

Beyond "fair" issue, Venkatasubramanian fails again (at least in the abstract) by not addressing "CEO of what?" A U.S. style, publicly traded corporation suffers from a lack of any meaningful oversight by the putative owners, the stock holders, who have virtually no input on the day to day (or quarter to quarter) operations of the business. I conjecture that the incestuous relationship between boards and CEO in that environment doesn't reflect the interests of those who actually forgo consumption to pay of CEOs. This structure leads to a legitimate public policy question.

Anonymous said...

"would want our government to come to come to the conclusion that for every payment there is an equal and opposite payer."
You know what this is called? The market, the antithesis of government. So long as prices have any meanings, only competitive profit can effectively coordinate producers with consumers with any accuracy. Bureaucratic budgets are arbitrary; there are no objective tests to gauge success or failure like there are with the entrepreneur (profit and loss).
-The economists will never be able to apply equations to human behavior in the way the mechanic does in engineering. Human's do not act as cogs in a machine, yet planners and these pseudo-scientific mathematical economists treat them as such, using their own value judgments as the objective measures. These concepts have done nothing more than produce policy action clouted in obscure and fallacious pseudo-scientific terminology which invariably help the politician to spend more.

Schepp said...

"You know what this is called? The market, the antithesis of government." I absolutely know it is the market. The antithesis of government again goes to far. The Government is constrained by the market force of people and institutions that give the gov. power.

If you look closer at my argument you will not see that I thought the government utilizes this concept well in it's salesmanship, but indicated that I wished government applied equal and opposite payment/payer rule.

I believe this is a true and valid rule. It is a parallel to a rule of physics that can effectively be applied to economics. I don't say all physical rules apply. I say that there is value in looking at possible ways of thinking that can be derived from testing if some physical rule principles can be applied to economics.

Andrew Stella said...

One definition of the state is that institution which holds a monopoly on violent force.

Just sayin'

Anonymous said...

I'd like to suggest that the charlatanism of economists has precipitated this situation - while it might not be evident to you guys in your echo chambers, your profession has lost a lot of respect recently.

When you hear jokes about economists from people in the Theater and Dance department(!), you know the economics profession has hit rock-bottom ;)

-An applied mathematician

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