'Econophysics' points way to fair salaries in free market

Jul 13, 2010 by Emil Venere
Venkat Venkatasubramanian, a Purdue professor of chemical engineering, displays some of the mathematics behind his new theory, "statistical teleodynamics," to show how free markets for labor promote fair salaries for workers and not the CEO compensation practices common today. Credit: Purdue News Service file photo/Andrew Hancock

A Purdue University researcher has used "econophysics" to show that under ideal circumstances free markets promote fair salaries for workers and do not support CEO compensation practices common today.

The research presents a new perspective on 18th century economist Adam Smith's concept that an "invisible hand" drives a economy to a collective good.

"It is generally believed that the free market cares only about efficiency and not fairness. However, my theory shows that even though companies focus primarily on making profits and individuals are only looking out for themselves, the collective self-organizing free market dynamics, under ideal conditions, leads to fairness as an emergent property," said Venkat Venkatasubramanian, a professor of chemical engineering. "In reality, the self-correcting free market mechanisms have broken down for CEOs and other in the market, but they seem to be working fine for the remaining 95 percent of employees."

Venkatasubramanian is proposing the use of and econophysics concepts to gain some insights into the problem.

"This is at the intersection of physics and economics," he said. "We are generalizing concepts from statistical thermodynamics - the branch of physics that describes the behavior of gases, liquids and solids under heat - to analyze how free markets should perform ideally."

In previous work, Venkatasubramanian used the approach to determine that the 2008 salaries of the top 35 CEOs in the United States were about 129 times their ideal fair salaries - and CEOs in the Standard & Poor's 500 averaged about 50 times their fair pay - raising questions about the effectiveness of the free market to properly determine pay.

In the new work, the researcher has determined that fairness is integral to a normally functioning free market economy.

Findings are detailed in a research paper that appeared in June in the online journal Entropy and is available at http://www.mdpi.com/1099-4300/12/6/1514/

A key idea in Venkatasubramanian's theory is a new interpretation of entropy, used in science to measure disorder in thermodynamics and uncertainty in information theory. He shows, however, that entropy also is a measure of fairness, an insight that seems to have been largely missed over the years, he said.

"Venkat's insight goes beyond the simple grafting of the mathematics of information theory and statistical physics onto the question of fairness of salary distributions within a free market economy," said Andrew Hirsch, a Purdue physics professor familiar with the research. "He has recast the notion of entropy into a context that has meaning and relevance for this particular problem."

Venkatasubramanian calls his new theory, "statistical teleodynamics," from the Greek telos, which means goal-driven.

"In statistical thermodynamics, we study the movement of large numbers of molecules," Venkatasubramanian said. "In economic systems, we have a large number of people moving around in a free market system, but instead of thermal energy driving the movement people are motivated by goals."

His theory describes how goal-driven "rational agents," or people, will behave in a free market economic environment under ideal conditions.

"The bottom line is that the free market does care about fairness," he said. "Clearly, the next step is to conduct more comprehensive studies of salary distributions in various organizations and sectors in order to understand in greater detail the deviations in the real world from the ideal, fairness maximizing, free market for labor."

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Yellowdart
2.4 / 5 (9) Jul 13, 2010
The article doesnt describe what is meant by "ideal" conditions.

However, The capitalist/free market system easily corrects itself when allowed to. Government interference which bails out failure and extorts success is why CEOs are out of balance. It's also why we will continue to remain in a recession so long as that is the policy.

Donutz
3.8 / 5 (10) Jul 13, 2010
The article doesnt describe what is meant by "ideal" conditions.

True. Under ideal conditions, communism should work. Unfortunately, reality includes dishonest and unscrupulous people who can work the system to their advantage.

However, The capitalist/free market system easily corrects itself when allowed to.


Sure, as long as you're very careful to define 'correct' as what the market does. In reality, the capitalist system is no more self-correcting or self-healing than any other, unless you are willing to avert your eyes, plug your ears, and yell "LA LA LA LAAAAA". The 2009 recession was caused by out-of-control capitalism, not out-of-control government. Unless you're one of those yutzes who are trying to blame it on Clinton...
trekgeek1
4.3 / 5 (8) Jul 13, 2010
I believe in the free market, but you must have government regulation. A corporation wants to make money, that is all. Rarely do they have any scruples. Their purpose is to make money for the stock holders and they don't care how they do it. Government regulation is like rules in sports. You allow the teams to win with whatever strategy they want within certain fair rules and boundaries. I've recently realized while laughing to myself about the verbose, overcomplicated government laws and regulations, that they are complex because corporations and individuals try to find any loophole possible. If people weren't so intent on breaking the system, we could have simpler laws and regulations. Complexity comes from necessity.
Parsec
4.2 / 5 (6) Jul 13, 2010
The article doesnt describe what is meant by "ideal" conditions.

However, The capitalist/free market system easily corrects itself when allowed to. Government interference which bails out failure and extorts success is why CEOs are out of balance. It's also why we will continue to remain in a recession so long as that is the policy.



I agree to some degree with this, but heatedly disagree with your generalization. Consider this analogy. Highways and roads are populated with cars all of which have goal driven behavior. Regulations that try and tell people how to get from any point to another point are enormously counterproductive, but traffic lights, speed limits, and cops to enforce these rules are necessary.
Yellowdart
2.2 / 5 (5) Jul 13, 2010
Under ideal conditions, communism should work.


Well it wouldnt. Communism a form of socialism assumes everyone is "equal", which is an unrealistic goal as you go on to state that people are not able to be honest or scupulous. Capitalism, simply allows you the individual to develop and sell and make a living how you chose, for better or worse, at your own risk and to buy how you wish to buy.

The 2009 recession was caused by out-of-control capitalism, not out-of-control government. Unless you're one of those yutzes who are trying to blame it on Clinton...


You mean 2008? There is alot of blame to go around, but the government has been just as out of control, esp from Bush and Obama practices. You can not support failure or extort success, esp while overspending. The market comes calling, it will not allow debt to accumulate forever.
Slim934
3 / 5 (1) Jul 13, 2010
HAHAHA! This is one of the most ABSURD things I have ever read.

"It is generally believed that the free market cares only about efficiency and not fairness. However, my theory shows that even though companies focus primarily on making profits and individuals are only looking out for themselves, the collective self-organizing free market dynamics, under ideal conditions, leads to fairness as an emergent property," NEWSFLASH: This is precisely how mainstream economics is taught NOW and increasingly has been ever since Irving Fisher wrote his dissertation under the stewardship of Josiah Willard Gibbs. The idea that one can reasonably use mathematical models to model systems in which there are almost 0 constants is the height of hubris. Ludwig von Mises, Friedrich von Hayek, and now Hans-Hermann Hoppe again annihilated this methodologically silly nonsense numerous times. Most recently with "Economic Science and the Austrian Method".
Donutz
4.2 / 5 (5) Jul 13, 2010
You mean 2008?

Well, 2009 is when it really affected me, so I think of it as the 2009 recession. :-/
Well it wouldnt. Communism a form of socialism assumes everyone is "equal",

It doesn't actually, but it's kind of irrelevant to this discussion. Point is, capitalism is no more immune to cheaters. I have a pragmatic view that all government is more-or-less crap, but any is better than anarchy. You seem to have a more religious view about capitalism. I almost expect you to capitalize the word. Capitalism has its pros and cons just like any other system. I like being here better than in Cuba, but that doesn't mean I should ignore the warts.
Slim934
4 / 5 (4) Jul 13, 2010
I believe in the free market, but you must have government regulation. A corporation wants to make money, that is all.


Yes they do, but government bureaucrats do NOT want to do this? Your entire line of argument seems to imply that when people join the government, they essentially become angels and lose any wish to enrich themselves as much as possible. History shows us that this is folly. The problem is worse in government because they derive their income from theft as opposed to voluntary exchange. If a company screws me over I can STOP paying them. If I try to do that when the government does I get 1) thrown in prison or 2)shot dead for "resisting arrest".
As to laws being overly complicated? They become complicated government intervention always fails at its intended consequence. In order to fix this (and to maintain their power) the government adds more laws under the mistaken belief that they can fix what they just screwed up.
Yellowdart
3 / 5 (2) Jul 13, 2010
Parsec,

I agree with what you said. I know others view capitalism's free market as a freedom to do whatever. That is not what it means however. It has no problem with government regulation of criminal behavior. No problem with taxation either up to a point.

Where it is no longer capitalism, is when an entity such as the government, pushes or manipulates the market toward its own agenda. The housing market, the tech bubbles, etc were examples of this. In promoting certain avenues, it causes problems in the long run...especially if it seeks to support those practices post failure.
Yellowdart
3.7 / 5 (3) Jul 13, 2010
Point is, capitalism is no more immune to cheaters.


I'm not disagreeing with you here. If the market has to correct itself, it means there were cheaters, higher risk takers, etc.

Why it will correct itself faster, compared to others forms, is because it allows the people to be the majority investor. People will invest where they have confidence. Market crashes are a knee jerk response to a sudden loss in confidence.

This is why, supporting failing companies, muddies the waters. It is why extorting successful businesses slows down consumer investment. Clear the waters, and people will readily invest again.

Dont push bubbles, and the response of the market will not be so steep.

It will always have down periods, thats just life. But you'll minimize the volatility and steepness of such down periods, if you let market flow on its own (aside from criminal behavior)
marjon
3 / 5 (1) Jul 13, 2010
Free markets can account for fraud if people are free to choose to purchase and sell.
Madoff was able to steal people's money for over 10 years because the government regulators failed to investigate in spite of warnings from a COMPETITOR. Madoff's victims depended upon government regulators who provided a false sense of security.
Markets shows what happens when trust is lost: Arther Anderson is no more.
Markets work best if its bad players are not protected by bribed politicians.
Capitalism has provided such prosperity to billions because it depends upon individual self interest instead of altruism, as communism does.
purringrumba
not rated yet Jul 14, 2010
The article doesnt describe what is meant by "ideal" conditions.


Actually, it does.

The author (Venkatsubramanian) defines ideal as 'perfectly competitive, transaction costs are negligible, there are no externalities, and market participants have perfect information.'
antialias_physorg
not rated yet Jul 14, 2010
ideal conditions would be an infinitely repelenishing environment, infinite consumers and infinite competition in all aspects of the market (so as to prevent companies from forming cartels), total independence of government from companies and perfect unbribability of any government official.
Under those conditions you will, eventually, get a harmoniuous and fair economy.

But as anyone will tell you: None of the above conditions are even remotely met in reality.
marjon
not rated yet Jul 14, 2010
ideal conditions would be an infinitely repelenishing environment, infinite consumers and infinite competition

That is whole point of economics, allocation of SCARCE resources.
total independence of government from companies and perfect unbribability of any government official.

How about a government that has limited power? If he government has little power to control, there is little need for bribes. That was the whole point of dry counties, no? The police get a cut of the moonshine. The Saudi princes run booze into the country.
Because of excessive government regulations, there is profit in a black or gray markets.
Hong Kong prospered because of low import taxes and a government that had limited power to meddle.
marjon
not rated yet Jul 14, 2010
"Congress creates, on average, one new crime every week. Federal agencies create thousands more -- so many, in fact that the Congressional Research Service itself said that merely counting them would be impossible.

This is a bad trend. As Lao Tsu said, "The more laws and order are made prominent, the more thieves and robbers there will be.""
http://www.realcl...299.html
fmfbrestel
1 / 5 (1) Jul 14, 2010
You are ALL trolls. Bunch of pseudo-religious talk about free market, not one mention of executive pay. seriously, take your trolling and start a new thread in the forums.
xponen
not rated yet Jul 14, 2010
salaries of the top 35 CEOs in the United States were about 129 times their ideal fair salaries

Have not anyone seen this statement?? Why is it that they get paid soo much?! 12900% more money than their ideal salaries!? (the rest of the employee, 95% of them, get the ideal salaries, but the CEO got 1200% more!)

If free-market can correct itself (as suggested by the 'invisible hand' idea), then why did this happen?? clearly, what happen here is that; free-market is unable to be ideal. -All idealism, including free-market is UNABLE to be ideal!! this is the reality.

Reality suck, the textbook is pure fantasy.
xponen
not rated yet Jul 14, 2010
I Googled "CEO compensation practice", and found many research paper written about it. I guess this area of economics (CEO salaries) is still being studied and improved. -So, it is possible that the said CEO was (really) being overpaid, because it is possible that the company thought it was right to do so, a method for them to compensate for the CEO's contribution.
marjon
not rated yet Jul 14, 2010
You are ALL trolls. Bunch of pseudo-religious talk about free market, not one mention of executive pay. seriously, take your trolling and start a new thread in the forums.

CEO stands for Chief Executive Officer. He is the CEO of a corporation that has a board of directors and usually millions of shareholders who have the opportunity to determine the salary and compensation of such corporate officers. The structure is quite democratic.
Those who are opposed to a CEOs compensation package can sell all their stock, or vote all their stock and/or stop buying the products of that company. Why must you immediately attempt to use the force of the state to control such free contractual arrangements?
PinkElephant
not rated yet Jul 14, 2010
The structure is quite democratic.
Those who are opposed to a CEOs compensation package can sell all their stock, or vote all their stock and/or stop buying the products of that company.
Uh-huh. And of all the individual investors out there, how many actually know or care about the governance of their respective holdings, which many of them hold through mutual funds in their 401Ks, and many (speculators) don't hold for more than a few days? Ideology meets reality: the vast majority of people are lazy and ignorant louts who can't be bothered to participate in any "democratic" system of governance, be it political or economic. In stock markets just like in politics, most eligible voters never bother to either learn the issues, or to even show up for the voting. The only ones with any real economic influence, are large holders -- i.e. the financial oligarchs. Not very coincidentally, they're the same people who hold the only real influence over politics, as well.
marjon
1 / 5 (1) Jul 15, 2010
"He shows, however, that entropy also is a measure of fairness,"
I would suggest that the amount of energy required to reduce entropy a measure of efficiency and wealth creation. I don't know how 'fairness' plays any part. 'Fairness' is a subjective measure.
Wealth can only be created by nuclear energy (fusion or fission). Solar energy creates food stuffs. Stored solar energy (hydrocarbons) reduce the entropy of minerals to to make steal, Al, etc. Wealth is subjective as well. A company or country that produces tons of steal that sits and rusts or food it can't eat is not creating wealth. Wealth is created when such products have value determined by the people who need/want such products.
The goal of a prosperous economy should be to reduce entropy most efficiently.
marjon
1 / 5 (1) Jul 15, 2010
And of all the individual investors out there, how many actually know or care about the governance of their respective holdings,

Whose fault is that? If you care about the CEOs pay for a stock you own, you have a path of action, if you really care.
they're the same people who hold the only real influence over politics, as well.

We will find out this NOV will we not?
The point is the system exists for individual stockholders and voters to have their say. But, like Friedman, do you prefer dictators?
PinkElephant
5 / 5 (1) Jul 15, 2010
Like I already said: ideology, meet reality. Enough said.
Yes
5 / 5 (1) Jul 17, 2010
There are no rich without poor supporting them.
There are no rich countries without poor countries supporting them.
Conclusion:
There will always be poor people and poor countries.
Bottom line is that them poor need to eat and to drink and support their children with a roof, because if the poor die from rich usurping, then the richness will die with the rich and the poor, until there are only poor and no rich that usurp them.
So if the rich die, then you will still have the poor.
Conclusion: Rich people cannot support themselves and usurp the poor....
CEO's important?
The most important people in society are the farmers, without them the rich and many poor die. And what do we pay them most important creatures among us for their most important work?
Answer: Next to nothing!! If them farmers die?
Try to eat a pentium quad core processor or a $100 bill.
What the heck is poverty?
marjon
1 / 5 (2) Jul 17, 2010
""I've never got a job from a poor man in my life," Mrs. Fisher told me. "When you stop the guy at the top from making a dollar, he'll shut down and just live well.""
http://www.freedo...-my-life
Yes
5 / 5 (1) Jul 17, 2010
I've never got a job from a poor man in my life

This is not because it is impossible. This is either because we have been taught this as truths or what I think it is in our instinct.
I think that the motives for working of many poor are fear of having nothing to eat, fear of not having a roof and fear of what they think thinks their CEO and their neighbor.

Our motives should be passion for our work done and pride in the result of this work. However passion is of the past and replaced by fear.

That is why the above described model works.
However they should change the "goal driven" 5% by "fear driven" 95% to match reality.
marjon
not rated yet Jul 17, 2010
I think that the motives for working of many poor are fear of having nothing to eat, fear of not having a roof and fear of what they think thinks their CEO and their neighbor.

Fear? How about survival?
What do the bums in San Francisco have to 'fear' when the city pays them to live on the street?
The most important people in society are the farmers, without them the rich and many poor die.

I was raised on a farm and agree farming is too important for governments to control with subsidies. New Zealand has discovered this and their farmers are prospering providing products people want to buy.
Yes
not rated yet Jul 17, 2010
And finally, CEO's like recessions.
This gives them power. I can see them justify all kind of evil actions saying: I had to cut all those jobs because of the recession.
Maybe the CEO receives less money, however he gains power. And money may be convenient, but power is addictive.
So while CEO's motivations shifts from money to power, many are unconsciously not interested in recuperation. Recuperation means back to the standard set of rules.

I prefer money hungry CEOs over a power hungry type.
But actually many companies can do without.
marjon
not rated yet Jul 17, 2010
And finally, CEO's like recessions.
This gives them power. I can see them justify all kind of evil actions saying: I had to cut all those jobs because of the recession.
Maybe the CEO receives less money, however he gains power. And money may be convenient, but power is addictive.
So while CEO's motivations shifts from money to power, many are unconsciously not interested in recuperation. Recuperation means back to the standard set of rules.

I prefer money hungry CEOs over a power hungry type.
But actually many companies can do without.

So does the state. FDR ursurped much authority during the depression and BHO is following in his footsteps. The CEO is not the owner. How does he take power from a board and shareholders?
Szkeptik
not rated yet Jul 18, 2010
As people working in natural sciences all know, "ideal conditions" usually don't exist outside the laboratory.
marjon
not rated yet Jul 18, 2010
As people working in natural sciences all know, "ideal conditions" usually don't exist outside the laboratory.

So why do so many claim they know what will happen in 10,20,...100 year?
marjon
not rated yet Jul 18, 2010
As people working in natural sciences all know, "ideal conditions" usually don't exist outside the laboratory.
Correction:
So why do so many claim they know what will happen in 10,20,...100 years?
includao
5 / 5 (1) Jul 19, 2010
"His theory describes how goal-driven "rational agents," or people, will behave in a free market economic environment under ideal conditions."

Wrong. People are not 'rational agents'. People make irrational choices. People are driven by arrational/irrational processes too, as evolutionary psychology points out using game theory. Whenever there are “externalities”—where the actions of an individual have impacts on others for which they do not pay or for which they are not compensated—markets will not work well. But recent research has shown that these externalities are pervasive, whenever there is imperfect information or imperfect risk markets—that is always. Whenever markets are incomplete and/or information is imperfect (which are true in virtually all economies), even competitive market allocation is not constrained "Pareto efficient".
includao
5 / 5 (1) Jul 19, 2010
In 2001, the Nobel Prize in Economics was awarded to George Akerlof, Michael Spence, and Joseph E. Stiglitz "for their analyses of markets with asymmetric information, which is the condition that real markets face. Not some ideal condition like this model proposes.

Or some model provied by some cult with no scientific rigor like the Austrian School. Critics have concluded that modern Austrian economics generally lacks scientific rigor, which forms the basis of the most prominent criticism of the school. Austrian theories are not formulated in formal mathematical form, but by using mainly verbal logic and what proponents claim are self-evident axioms. Mainstream economists believe that this makes Austrian theories too imprecisely defined to be clearly used to explain or predict real world events.
includao
5 / 5 (1) Jul 19, 2010
Bryan Caplan: what prevents Austrian economists from getting more publications in mainstream journals is that their papers rarely use mathematics or econometrics.

http://goo.gl/Q7Mb
http://goo.gl/A9DE
marjon
1 / 5 (2) Jul 19, 2010
Asimov discussed the use of mathematics to model human behavior in Foundation.
How precise are those models?
The Austrian school seems to be the most honest as economics is must involve human actions.
The MATLAB economists just blew up Wall Street. Very smart?
ArtflDgr
not rated yet Jul 19, 2010
The bean counters improved war too. they equated killing and massive killing with winning, so they gave us, kill ratios... generals before them thought that a win with no deaths was a win, after them, killing as many as you can got a better score.

ie... we will just game the formula...

but scientific socialism (communism) planning has lead to millions of people tortured to death and starved.

the best thing he can do, is not help
ArtflDgr
not rated yet Jul 19, 2010
Its as simple as, cheating is wasteful and unproductive comparatively, and so efficiently weeds out cheating
Its NOT an emergent property, it’s a key thing as to efficiency wich is ignored given the feelings basis of the argument.
Skeptic_Heretic
5 / 5 (1) Jul 19, 2010
Fear? How about survival?
What do the bums in San Francisco have to 'fear' when the city pays them to live on the street?
Being lit of fire, raped, assaulted, heat stroke, hit by a bus, no medical care, etc.
ArtflDgr
5 / 5 (2) Jul 19, 2010
I just read the paper. its worthless...

he does nto prove anything except that in a fully contrived world of his design, where everone is omniscient, doesnt actually work, and so on... is fair.

there is nothing of operative worth in the paper, as a system of omniscient players is always fair.

hayeks explanation which erned him a nobel is better. (as is misis)

dishonesty is very costly...

the fact that a hasidim jewish man in the diamond district can do his business with a handshake, and a liberal ceo trained by harvard has to spend a quarter million in legal time, tells one all they need to know as to how fairness works.

its pretty funky when the people believe some moral imperative that comes from people who claim there are no morals... (hint: its a fix and they are lying).
Pyle
not rated yet Jul 19, 2010
Worthless? This paper explores the application of principles/equations that explain behavior in physical systems to social systems. Pretty cool exercise. Are there unaccounted for variables that have effects that are unparalleled in the physical systems, yes. But by applying these concepts to the economic setting the author was able to identify an outlier that requires explanation. Is this novel, or otherwise illuminating, probably not. I challenge those who think CEO's aren't overpaid to come up with a similar exercise using thermodynamics, or other physical system, to demonstrate that the high salaries paid CEO's are in fact in line with, analagous to, a phenomenon, etc. in the physical system.
marjon
1 / 5 (1) Jul 19, 2010
Fear? How about survival?
What do the bums in San Francisco have to 'fear' when the city pays them to live on the street?
Being lit of fire, raped, assaulted, heat stroke, hit by a bus, no medical care, etc.
You must be joking. Bums have no medical care in SF?
Skeptic_Heretic
not rated yet Jul 19, 2010
You must be joking. Bums have no medical care in SF?

So you home in on that. Brilliant.
marjon
1 / 5 (1) Jul 19, 2010
You must be joking. Bums have no medical care in SF?

So you home in on that. Brilliant.

Of course you ignore that when the government subsidizes something, like bums, you get more.
Yellowdart
not rated yet Jul 29, 2010
I challenge those who think CEO's aren't overpaid to come up with a similar exercise using thermodynamics, or other physical system, to demonstrate that the high salaries paid CEO's are in fact in line with, analagous to, a phenomenon, etc. in the physical system.


Would baseball elites like Arod be a similiar analogy? Arod would certainly seem well overpaid year after year when he did not produce a championship, but I would imagine to most Yankee fans now, he is worth the price paid. To everyone else not a Yankee fan, he's still overpaid.

Similarly CEOs are well overpaid, but if I'm invested in a company, I want the best at the top, so long as they increase the company's wealth and production and in a legal fashion. Failure to do so, and the overpaid CEO definately goes.
Yellowdart
not rated yet Jul 29, 2010
Even if you attempt to cap CEO pay, there will be loopholes (politicians just want their share), companies will find ways to hire the best of the best. And the left over money the company workforce still wont see.

Scientifically, for individual companies, I would think you could show the break even point per CEO. At some point overpaying a CEO will cost you reliability, skill, productivity and education in your workforce over the long run.

So just like in baseball, you gotta find the piece that fits at the best cost. The all star free agents (CEOs) are always going to get paid way more...but th emoment they fail to deliver, is when consideration begins to remove them.
Skeptic_Heretic
5 / 5 (1) Jul 29, 2010
Very simple, if your bonus, divided by the number of months in the year worked is greater than the yearly salary of your lowest paid employee, you're overpaid.