Thursday, November 8, 2007

Economist's Notebook: Winner-Take-All Markets

One interesting graph that the OCPP produced regarding income inequality in Oregon that really caught my eye was this:

It caught my eye because of the title. Winner-Take-All (WTA) markets are one economic explanation for some of the income inequality we see in the current economy, especially at the very top. The OCPP uses the term in a negative way, but there is a very interesting economic theory behind the term.

The WTA market theory cannot explain all of the observed inequality, but it does go a long way to explain the increasing rewards to the very top of the income distribution, and it is very interesting. The story goes like this: in a modern economy where performance is easily recorded, duplicated, shared or otherwise increasingly impactful, the rewards to being the very best are dramatically higher than being second best. The recording industry is a good example. Before recorded music, musicians were travelling live performers. Being the best may have brought a few more people to each show, but overall the ability to leverage being the very best was small. With the advent of recorded music that was easily duplicated and distributed, being the very best suddenly meant potentially millions more records sold. Professional sports are another example, with increasing media coverage and distribution of live performances, the difference between the best performers in the MLB, say, versus the minor leagues has become humongous even though the difference in ability of a MLB player may be ever so slight relative to a AAA player. But this is not just an entertainment story. You can tell the similar stories with software programming, journalism, investment banking and even corporate leadership. These are all markets where the rewards at the top are hugely different then the rewards just below the top. In cases like CEO pay the theory says that while the difference between the best production line worker and the second best is a pretty small difference in corporate earnings, the difference between the best and second best CEO can mean tens of millions of dollars in corporate earnings. In software the theory says that the rewards grow as one product becomes the standard through something known as network externalities (think of the domination of Windows in the PC market). Finally, instances where there is reward by contest like in litigation can mean that the top litigators can reap most of the spoils.

So the key to WTA markets is the fact that though human capital differences may be small, the rewards are not. And, by the way, despite the title, there does not have to be a single winner in these markets, MLB players in general, top recording artists, top CEOs are all groups of people rewarded disproportionally to the difference in their skill relative to those just below them.

In the next post I take this theory to a local example in my favorite subject: Beeronomics


gruntworkerwest said...

How do you explain markets where large productivity differences translate into scant compensation differences?

For example, adjusting for differences in local wage structures, the most productive hamburger flippers probably earn only a few cents more than the least productive hamburger flippers.

gruntworkerwest said...

p.s. there's a question on your Measure 49 post which is still waiting for a response.

Patrick Emerson said...

This is really the same story in reverse. An incredibly burger flipper can't really produce that many more burgers than a bad one - so the value of this productivity difference is minimal. But if there was some way to translate that productivity differential on a mass scale then the returns would be quite different as well.

I suspect, however, that high productivity individuals tend to be high productivity in many areas and so will tend to migrate to professions where their extra productivity can make a big difference in earnings.

Thanks for alerting me to the unanswered comment, I have now done so.