Dan Price, CEO of Seattle-based Gravity Payments, made headlines this past spring when he announced a plan to pay everyone in his company at least $70,000 per year, regardless of their position or tenure. His employees wildly cheered him and he was lionized by many in the media for his people-oriented, forward-thinking approach to compensation.
All those with a basic understanding of economics and human nature knew better.
Forbes and others are now reporting how right these skeptics were. In just a few short months and before the plan could even be fully implemented, the Gravity Payments ship has run onto the rocks. It seems that his highest achieving employees found themselves riled by the idea that their salaries weren’t much more than the newest intern. I know; a real head scratcher.
The results are potentially catastrophic for the company. Some of Price’s key people flew the coop. A few important customers are said to have also left, nervous about the company’s long-term viability and suspicious that the policy would ultimately be priced into their services. Price himself is reported to be experiencing difficulty with the transition from his previous $1 million salary to $70K. He’s supposedly had to rent out his house. I’m sure there are plenty of other adjustments ahead for him – $70K doesn’t go as far as it used to.
You’re probably in one of two camps on this issue: 1) You’re with Dan and the other idealistic hopefuls in wondering what went wrong and pondering ways to fix the unexpected problems, or 2) you’d say something like: “no s#*t Sherlock.”
I’m sure Dan and his like mean well and are in the main lovely people. They just don’t quite appreciate a few important truths. It’s not all their fault. They have been systematically taught to think in a way that fails them. Today, most Americans are victims of this conditioning.
The case of Gravity Payments highlights two concepts that are important in our critical thinking. The first is in the field of economics. Everybody needs to understand the basics of market dynamics, which dictate the optimal allocation of resources. Here is the classic chart that illustrates the concept:
This illustrates the relationship between providers of goods and services and their consumers. One side of the equation, called the supply curve, maps out the quantity that a market will provide at any particular price point. More revenue = more production. Not too hard to picture.
The other representation, known as the demand curve, plots the quantity of the good/service that will be purchased at each price point. Higher prices mean fewer will buy the good. Makes sense, right?
Markets, when operating in free conditions (a caveat that exists less and less frequently), converge to a point of equilibrium. This equilibrium matches the available good or service with the demand for that product. The price is determined by this natural force and it facilitates the most efficient allocation of goods, whether it is peanut butter or accounting services.
Our government (or sometimes consortia of government and/or private entities) often tinkers with the equation to produce a result that they deem superior. What everyone must understand is that these ends are only superior from a particular vantage. For the society as a whole, it is always a net long term loss – a sacrifice – to impose price controls, tariffs, quotas, or caps. Such policies invariably cause surpluses and shortages that damage real people.
People most often lose sight of this reality when it comes to wages. There is a sense that certain people deserve or don’t deserve certain wages. Much talk centers around the “outrageous” salaries that professional athletes, entertainers, or CEO’s receive. Conversely, many look to a minimum wage that should be imposed upon the market so that people may avoid squalor. They fail to appreciate that the market works whether they agree with its determinations or not.
The compensation of athletes and entertainers is a direct function of the money generated from their talents. They’ve always been well paid, but it’s more dramatic today because these industries generate massive amounts of money and the players have negotiated over the years a bigger piece of the pie that once went in greater proportion to team owners, record companies, and movie studios.
In the case of CEO salaries, companies compete for the services of those whom they believe the most competent to lead their organizations. The price for this talent is set by competition that will offer greater incentives in order to attract top talent to their firms. This populates the CEO demand curve. The value, or at least the perceived value, is informed by the needs and economics of the industry.
This same dynamic sets the price for labor at the lower end of the spectrum too. Minimum wage laws, well-intentioned they may be, damage the people they are meant to help. Remember, when prices are artificially increased, fewer goods are consumed. When that happens, providers shrink their operations or disappear altogether. This means fewer available jobs. New dynamics emerge that affect not only the lowest wage earners but the prices for items all along a supply chain where their labor is involved. This results in a higher cost of living to go along with fewer employment prospects. I’ll let you fill in the blank on who gets hit hardest by these two damaging effects.
Markets are complex and ever-changing. This is perhaps one reason why we sometimes do not see these kinds of basics. But principle does not change. If you want to reach the highest quality decisions for you, your family, your organization, your community, or your nation, you must do so with respect to first principles.
This brings us to the other lesson evident with Gravity Payments. People are people. They’re going to behave as people do. This means that, no matter how educated, well-meaning, enlightened, etc., people will react in predictable ways to specific circumstances. The key thing to remember here is that people will not accept, over the long term, that which they view as unjust.
Known since the time of Adam Smith, the phenomenon was called the Equity Theory of Motivation by J. Stacy Adams in the 1960’s. It means that people do not operate in a vacuum. They pay attention. It means that if you notice someone making relatively the same as you but who contributes less, you won’t like it. You will be likely to either ask for a raise or if you’re one of the passive-aggressive among us, you’ll find yourself simply contributing less. You and the organization suffer. This is precisely what happens in collectivist systems such as communism and socialism and it is why they ultimately fail.
A firm’s wages are priced into its products. Its products must offer value relative to the other options consumers have. So it is the competitive landscape that places the range in which a firm can remain viable and sustain its compensation policy. Dan Price was altruistically willing to reduce his personal compensation to share with his team. He lost sight of the effects on others on his team, not to mention his customers.
When we advocate “beneficial” policies such as cap and trade, minimum wage policy, and over-regulation, we likewise cause inefficiencies that cause far more harm than the benefits of the policy. Experience and history shows that markets collect and disseminate more wisdom than even the smartest among us. The most successful leaders have learned to best serve others not by managing markets, but by clearing barriers so that their organizations become more aware and agile as they systematically contribute to the well-being of its constituents.