Dialogue: Income inequality hinders nation's economic growth

Such is New Zealand's winner-take-all marketplace that the huge fee paid to Tiger Woods was hardly abnormal, writes PETER LYONS*.

The appearances in New Zealand of Tiger Woods and Anna Kournikova illustrate an interesting anomaly in the economic logic of how markets operate.

Greg Turner's evident frustration was attributed to professional envy, but perhaps his feeling was to some extent justified. Was the $4 million paid to Woods a fair market reflection of his entertainment value in contrast to the $170,000 paid to the New Zealand Open winner?

Income inequalities in virtually all Western economies have mushroomed in the past 20 years. Economists are at a loss to fully explain the reasons behind this.

Pure market theory attributes income inequalities between people to differences in productivity. This productivity is, in turn, determined by differences in human capital - skills, education, training, natural talent - between individuals.

This argument would suggest that Tiger Woods' golfing ability is many multiples greater than that of any other golfer competing in the Open.

This human capital argument for income inequalities has been augmented by a number of other explanations to explain extending them. These include increased premiums paid to high-skilled workers because of technological advances and skill requirements, the impact of casualisation and contract work and the effects of globalisation on wages paid to lower-skill occupations.

The key assumption of the human capital theory of income inequalities is that markets for workers (including professional golfers and tennis players) are purely competitive and that no individual or group of individuals has a commercial advantage over any of the other participants in that market. Returns are based mainly on performance relative to other market participants.

One of the more interesting theories to explain the growth in inequalities has been the concept of winner-take-all markets.

This theory suggests that some markets for products and services may not necessarily be fair in terms of how rewards are determined.

The returns to Woods and Kournikova from their visits here would seem to bear out many aspects of this theory.

The winner-take-all market is one in which a participant (or small group of participants) or a product gains a pre-eminence and is able to reap rewards above performance compared with other people or products. The idea is that success breeds success or that commercial advantage tends to be self-reinforcing.

Woods' payment was based on past performance, whereas other golfers at the tournament were paid on the basis of current performance.

Market dominance might be the result of a variety of reasons, such as astute marketing and product placement, rather than superior quality or pricing policies. For people and services it might result from past successes, educational opportunities, reputation, networking or sheer luck in being in the right place at the right time.

Remember that the theory is trying to explain income differentials of a magnitude that are unexplainable by human capital reasons, such as differences in skill or talent or performance. Why would the chief executive of a large corporation earn 50 times more than the average worker? It is unlikely to be because he or she is 50 times more productive.

Examples of products in winner-take-all markets include Microsoft's MS DOS or VHS videos or even Coca-Cola. It is debatable whether Microsoft's operating system is the most effective on the market but it is certainly dominant and is rewarded accordingly. This success reaches a stage where it is self-perpetuating.

The theory has interesting implications for a country the size of New Zealand which has embraced the market philosophy in the past 15 years. Because of the small size of many job and product markets here, the characteristics of winner-take-all are evident in many areas, such as entertainment, law, commerce, marketing and retailing.

It is, for example, difficult to justify the salaries paid to some of our top media personalities solely on the basis of relative performance or effectiveness.

Winner-take-all job markets tend to attract a disproportionate number of applicants. People are attracted by the glittering prizes for the few who succeed at the highest level.

As with Lotto, most people rate their chances of success far higher than the odds would suggest. Hence the number of aspiring lawyers, marketing graduates, fashion designers, professional sportsmen and entertainers.

Corresponding to this is a relative shortage of aspiring teachers, nurses, engineers and machinists.

This suggests a greater need for careers guidance to foster realistic expectations to avoid a waste of human potential. From an economist's viewpoint, it also implies a misallocation of resources and, therefore, inefficiency.

Another interesting implication of the winner-take-all theory concerns income tax for very high income earners. Reductions in upper-income tax rates have been based on the argument that high rates reduce the incentive for people to work harder and will cause a further drain of talent. High-income earners usually propound these theories.

The theory was put to the test when a high-profile media personality threatened to take his talent to Australia if his pay was reduced. Fortunately for our viewing public, radio listeners, CD buyers and book readers, this did not eventuate.

This might have been because of the realisation that his market pre-eminence and its corresponding rewards might not have transferred so readily to the larger, more competitive Australian market.

It could be argued that raising the upper-income tax rate for very high income earners could create opportunities for fresh-thinking, hungry, innovative aspirants in various job markets.

Certainly the performances by some of our business leaders would suggest a need for developing and fostering new talent. They, in turn, might eventually move on to greener, more lucrative pastures overseas and be replaced by more home-grown aspiring talent.

That would not necessarily be a bad thing if one accepts that a healthy capitalist society is based on creative destruction and ongoing reinvention.

In the past two decades, New Zealand has embraced an economic model which is dubious in its practical applications.

An overseas journalist once likened it to "a country that prided itself on its pragmatic nature encountering its first full-blown ideology". The legacy has been one of a huge growth in income inequalities, relatively poor economic performance and an increasingly dispossessed portion of the population.

These income inequalities, as a result of markets that are not particularly competitive even though the theory says they should be, may hinder future economic growth.

* Peter Lyons is the head of commerce at Marcellin College.