How markets magnify the role of luck and create the illusion of meritocracy…

It is not just about 1% and 99%. It is also about what makes nearly similar talented people enter the 1%. Why is it that people with similar talents earn such dramatically different incomes?

Robert H. Frank says luck matters greatly in those outcomes. People who are luckier and are chosen by so called market process continue to be eventually rewarded. Whereas others equally talented and not as lucky are left out:

Why do hardworking people with similar talents and training often earn such dramatically different incomes? And why, too, have these earnings gaps grown so much larger in recent decades? Almost no other questions have proved more enduringly fascinating to economists.

The traditional approach to these questions views labor markets as perfectly competitive meritocracies in which people are paid in accordance with the value of what they produce. In this view, earnings differences result largely from individual differences in “human capital”—an amalgam of intelligence, training, experience, social skills, and other personal characteristics known to affect productivity. Human capital commands a rate of return in the marketplace, just like any other asset, suggesting that individual pay differences should be proportional to the corresponding differences in human capital. So, for example, if Sue has twice as much human capital as James, her earnings should be roughly twice as large.

But not even the most sophisticated measures of human capital can explain more than a tiny fraction of individual earnings differences during any year. And since the distributions of intelligence, experience, and other traits across individuals don’t seem to have changed much during the past few decades, the human capital approach has little to say about growing pay disparities over time.

Human capital cannot answer these differences especially when difference between capitals is so small:

The human capital approach is also completely silent about the role of chance events in the labor market. It assumes that the more human capital you have, the more you get paid, which obviously isn’t always the case. Of course, most people in the top 1 percent didn’t get there just by being lucky. Almost all of them work extremely hard and are unusually good at what they do. They havelots of human capital. But what the human capital approach misses is that certain skills are far more valuable in some settings than in others. In our 1995 book, The Winner- Take-All Society, Philip Cook and I argued that a gifted salesperson, for example, will be far more productive if her assignment is to sell financial securities to sovereign wealth funds than if she’s selling children’s shoes.

If markets have been growing more competitive over time, why are the earnings gaps unaccounted for by the human capital approach larger than ever? Cook and I argued that what’s been changing is that new technologies and market institutions have been providing growing leverage for the talents of the ablest individuals. The best option available to patients suffering from a rare illness was once to consult with the most knowledgeable local practitioner. But now that medical records can be sent anywhere with a single mouse click, today’s patients can receive advice from the world’s leading authority on that illness.

Such changes didn’t begin yesterday. Alfred Marshall, the great nineteenth-century British economist, described how advances in transportation enabled the best producers in almost every domain to extend their reach. Piano manufacturing, for instance, was once widely dispersed, simply because pianos were so costly to transport. Unless they were produced close to where buyers lived, shipping costs quickly became prohibitive.

But with each extension of the highway, rail, and canal systems, shipping costs fell sharply, and at each step production became more concentrated. Worldwide, only a handful of the best piano producers now survive. It’s of course a good thing that their superior offerings are now available to more people. But an inevitable side effect has been that producers with even a slight edge over their rivals went on to capture most of the industry’s income.

Therein lies a hint about why chance events have grown more important even as markets have become more competitive. When shipping costs fell dramatically, producers who were once local monopolists serving geographically isolated markets found themselves battling one another for survival. In those battles, even a tiny cost advantage or quality edge could be decisive. Minor random events can easily tip the balance in such competitions— and in the process spell the difference between great wealth and economic failure. So luck is becoming more important in part because the stakes have increased sharply in contests whose outcomes have always hinged partly on chance events.

It then becomes a winner takes all market:

Winner-take-all markets generally display two characteristic features.

One is that rewards depend less on absolute performance than on relative performance. Steffi Graf, one of the best female tennis players of all time, played at a consistently high level throughout the mid-1990s, yet she earned considerably more during the twelve months after April 1993 than during the preceding twelve months. One reason was the absence during the latter period of her rival Monica Seles, who had been forced to leave the tour after being stabbed in the back that April by a deranged fan at a tournament in Germany. Although the absolute quality of Graf’s play didn’t change much during Seles’s absence, her relative quality improved substantially.

A second important feature of winner-take-all markets is that rewards tend to be highly concentrated in the hands of a few top performers. That can occur for many reasons, but most often it’s a consequence of production technologies that extend a given performer’s reach. That’s true, for example, in the music industry, which exhibits both features of winner-take-all markets.

Interesting stuff..

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