Classical microeconomics theory assumes that we are paid in accordance with our marginal contribution to output. That is what Greg Mankiw and most economists teach in Econ 101. Consequently, it makes sense to assume we cannot overpay most of the individuals who are highly paid. In some cases it is pretty clear that some of our super stars are paid in accordance with their contribution to output. Top athletes, rock stars and movie stars attract a lot of customers willing to pay high prices to watch them perform. Its hard to disagree with Greg Mankiw when he tells us that they are being rewarded for their rare skills. In most cases, however, it is not easy to determine the marginal contribution to revenue made by most workers. Many of our top earners are part of business overhead. For example, it is difficult to determine the contribution of most corporate executives to marginal revenue. Greg Mankiw argues that they are rewarded for their performance by corporate boards who able to measure their contribution to output. There are probably some top executives that are similar to star athletes and rock stars. On the other hand, just as most athletes and performers are not super stars, its likely that most of our top executives are not super stars. Moreover, its not clear that their contribution to a firms success is greater today than it was in the past. Therefore, its hard to explain why we pay top corporate executives many times more than we paid their peers in the past. It is also hard to explain why US executives are paid many times more than their peers in other countries. Something else must explain why executive compensation in US has reached its current levels.
Mankiw also argues that many of our top earners are rewarded for taking risks. Of course many of them do take risks but they are seldom taking risks with their own money. Wall Street bankers took excessive risks to earn a high return on equity. They were highly compensated for that risk but they suffered less from the financial crisis than those who purchased their flawed securities. Its quite possible that the incentive system that they operated under encouraged them to take excessive risks and to sell toxic securities to investors that were not honestly described.
Mankiw also argues that bankers are paid highly because they perform the difficult job of allocating scarce capital to its most productive use. That, of course, is what our textbooks teach students in Econ 101. Its hard to support that assumption when one observes our recent history. The dotcom boom and bust would not have happened if Wall Street banks had adequately allocated capital to its best uses. They made a ton of money by taking companies public that they would not have underwritten if they bore the cost of failure. They earned large fees taking them public, but they were not responsible for the losses that were suffered by gullible investors. Wall Street analysts also helped to misinform investors because they played an important role in recruiting and retaining clients. The clients were more likely to give their business to the investment bank that promoted their business prospects.
While it is possible to argue, as Mankiw does, that society benefits from the work done by some of our highest income earners. It is less clear how well that argument applies to many of our most highly paid individuals. For example, one of the fastest growing industries in America is the lobbying industry. Top lobbyists are rewarded primarily for the relationships that they have with politicians. A former member of Congress who joins a lobbying firm is paid a high multiple over their government salary. Influence peddling is not an uncommon way to earn multimillion dollar incomes.