Saturday, March 26, 2016

Theory of Extreme Wealth

Most people operate in reasonably efficient labor markets, the sort you might learn about in econ 101. There's a range of incomes, and the range is governed mostly by supply and demand. Basic manual labor has the highest supply and the lowest price. Work requiring more skill or education commands steadily higher prices. Both supply and demand are abundant enough that markets are liquid, and employer-employee relationships are reasonably fluid.

This realm of "ordinary" earnings does a good job up to the upper middle class, somewhere on the order of $100k annual earnings. Doctors have the highest earnings within the ordinary realm, thanks to very limited supply and very large demand. Similarly, engineers, statisticians, programmers, and other technical occupations command relatively high prices within the ordinary realm. But all of these occupations have an earnings cap, of sorts. Doctors or engineers rarely make more than $200k/yr unless they move into management or entrepreneurship.

Beyond the realm of ordinary income, typical market behavior starts to break down. For entrepreneurs or upper management of large companies, there is no simple market. What is the "demand" for entrepreneurs? What is the "supply" for upper management? In either case, we could try to define some rough measure of supply and demand, but there is certainly no efficient, liquid market for such occupations. Understanding higher levels of wealth requires venturing beyond econ 101 and into game theory. So how can we more effectively understand income at the extreme upper end of the spectrum?

What do all of the following have in common?
    - Upper management
    - Entrepreneurs
    - Investment bankers
    - M&A lawyers (mergers and acquisitions)
    - Real estate developers
    - Lobbyists
    - ...
Obviously, these are jobs with at least the potential for high wealth and status. But what unifies them from a game theoretic perspective?

All of these occupations solve "coordination games". These are problems in which everyone involved can gain by following some plan, but only if everyone else follows it too. Real estate developers are a good example. Future tenants are happy to commit if they know the building will actually be built, builders and architects will commit if the project is funded, bankers will provide funding if future tenants are lined up, and a handful of other parties are also involved. The real estate developer plays the role of coordinator, getting everyone on the same page so that the new building actually gets built.

Similar stories apply to managers, entrepreneurs, investment bankers, etc. Even within these occupations, larger and more complex coordination problems typically correspond to higher pay. Upper management and entrepreneurs tend to make more money at companies with more employees and more complex business relationships. IPOs, for instance, significantly increase coordination complexity, since managers must coordinate stockholders and the board. Pay for managers at public companies is correspondingly higher. Similar coordination complexity applies in a merger or acquisition, with corresponding large bonuses for the parties involved. Same for real estate developers, for whom larger projects mean more buyers, builders, bankers, and regulators. Same for lobbyists, for whom larger projects mean more lawmakers and bureaucrats spanning multiple departments.

Coordination also serves as an interesting delineator of class. Upper management, investment bankers, large entrepreneurs, etc. are all typical occupations of America's elites. As Michael Church has posited, the elite class is characterized largely by their social networks (original source is gone, but you can read a bit at SSC). The main asset of a labor-class person is their skills and physical output, the main asset of a gentry-class person is their education and ideas, and the main asset of an elite-class person is their network. But why is an elite's network so important? Picture it. An investment banker is trying to arrange a merger deal between two companies. Coordinating the two is a lot easier if the banker already knows at least some key people in both companies. The more people they know, and the closer those people are, the easier it is to coordinate. If your main business is solving coordination games, then being friends with the people you need to coordinate makes the job a lot easier. Coordination problems are the reason why elite networks matter in the first place.

The moral of the story is that, if you're after extreme wealth, "networking" is important but not the main goal. Rather, the goal is to solve big, complicated, highly lucrative coordination problems, and knowing the right people is often a useful means to that ends.

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