"Superstar Economics" & The Market for Laterals

Using as a "hook" the dismissal of Tom Cruise from Paramount Pictures by Sumner Redstone, today's NYT has a piece in the Business Section (also here for those of you not members of the obnoxious "Times Select"), "A Big Star May Not a Profitable Movie Make," serving as a potted introduction to the sub-specialty of the study of income distributions often referred to as "Superstar Economics."

Most familiar in the worlds of sport and entertainment, it's a well-known phenomenon, and one that economists over the past 20 years or so have devoted some effort to quantifying.  For example, the Princeton economist Alan Krueger found that from 1983 to 2003, the share of concert revenue taken by the top 5% of stars increased from 62% to 84%.  Michael Jordan's impact on basketball viewership—which, since his retirement, could be characterized as "live by the sword, die by the sword," from the perspective of the  NBA—is well known.

But the question the economists and profit-maximizing businesspeople should want the answer to remains this:  Assuming we grant that (usually, most of the time, under general circumstances, etc., etc.) superstars bring in more revenue, does that make the venture more profitable?  Or, do expenses associated with the superstar, primarily his/her own remuneration, capture essentially all the added value they bring, leaving no extra profit for the business?

In law firm land, the issue is what we pay laterals:  In terms of guarantees, up-front bonuses, etc.  By and large, are marquee laterals a good investment for firms, or not?  Do laterals (both individuals and practice groups) add to the recruiting firm's overall profitability, or do they tend to capture the capitalized value of their future revenue streams for themselves?  Do we have enough data to make any convincing generalizations?

About a week ago, a partner in an AmLaw 10 actually posed this question to me in an email, and I had occasion to pursue it with two economics professors, one at Northwestern's Kellogg Business School, and one at Chicago's Business School.   Essentially, one responded that while it was "a VERY interesting question, I don't have the answer to it," and the other, "Good question.  I am afraid that my data don't let me investigate it."

But even if they didn't have sufficient data to nail the answer, we engaged in a highly informative colloquy, referencing among others the Scottish economist David Ricardo (1772—1823), who made a fortune as a stockbroker and loan broker (dying worth over $100-million in today's dollars) after his family disinherited him for marrying outside the Jewish faith.  Coming to economics only in his 30's, after having read The Wealth of Nations, he's best known for his theory of comparative advantage, the basis for every sane economist's core belief in free trade.  ("Comparative advantage," while a wondrous concept, is a bit far afield from our discussion today to go into; but we may some day.)

The other seminal notion Ricardo gets credit for is the somewhat obscurely, or misleadingly, named "theory of rents."  In economics lingo, "rents" are simply above-normal returns, having no necessary connection whatsoever to landlords and tenants, and Ricardo's theory helps explain who "captures" the above-normal return.  (Ricardo simply happened to develop the notion in the context of what farmland would rent for.)   The theory is simple:  Since a bushel of wheat sells for the same price whether it comes from productive fields or unproductive fields, tenant farmers will be willing to pay more to rent an acre of a productive field than they'll pay for an acre of an unproductive field.  (Think:  Law firms will pay more for a rainmaker than a grinder.)

But Ricardo's insight was that the benefit of the supra-normal productive land is not captured by the farmer, but by the landowner.  A rational landowner, free to rent his land to any one of a plethora of potential farmers, will choose the farmer willing to pay the most—and "the most" in this circumstance means about one cent less than the value of the increased productivity to the farmer.   Here's how one of my professor-correspondents put it:

"Ricardo's dictum that rents tend to flow to those with the scarce resources seems applicable. If I am a superstar lawyer, economist, or baseball player, there will be competition for my services and this competition will lead me to appropriate most of the proceeds associated with my production. Law firms might be able to assess these proceeds better than most other firms, but regardless they shouldn't expect to collect much value from bringing in a superstar lawyer who has other, equally good alternatives...."

Absent data, this is more by way of surmise than definitive answer, but I'd be interested in any readers' experiences in this area; I'll report (with or without attribution, as you prefer) anything I learn.  Yes, I know that "three anecdotes are not data," but it appears as if the definitive data-set in this area may not yet exist, so let's get by on what we've got.

Finally, the Chicago economist Sherwin Rosen wrote a paper over twenty years ago called simply "The Economics of Superstars," which has many pregnant observations, including these:

• Economists have known at least since the days of the famous Italian Vilfredo Pareto that the curve of income distribution has a very very long right-hand "tail:"  In other words, if you skiied down the curve of income distribution from its peak at the median,  you would have a short steep descent to the left (all income below the 50th percentile) and a very long gradual slope to its right (income above the 50th percentile).
• To the extent promotion by, or distribution through, mass media is germane to earnings in a given sector, the odds of superstars emerging is reinforced.  Consider:  While there were surely hundreds and hundreds of comedians making a living in the US during the vaudeville era, how many Jerry Seinfelds are there today? 
• Sports, as noted, are another arena providing fertile ground for superstars.  Rosen claims that " The top five money winners on the pro golf tour have annual stroke averages that are less than 5 percent lower than the fiftieth or sixtieth ranking players, yet they earn four or five times as much money."  And a pitcher who can win 20 games in a season is paid far more than what two 10-game winners will earn.
• Another critical factor tending to the emergence of superstars hits home:  They will emerge where "poor talent is an inadequate substitute for superior talent."  (To economists, "substitute" has technical meaning:  It conveys that X is a reasonable substitution for Y, depriving the consumer of no significant value, as coffee might be for tea, or a bagel for a muffin.)  Here, Rosen brings the point to us directly:  "A company engaged in a $30 million treble-damages lawsuit is rash to scrimp on the legal talent it engages. Stockholders and directors would look askance at hiring mediocre talents under those circumstances."

This all begs the question of equity, does it not?  Indeed, as Rosen so concluded over 20 years ago:

"Is all this fair? Probably not, Few people grow to be seven feet tall, never mind with the agility of a cat. Fair or not, it is the necessary and natural outcome of the unusual technology with which we now live. The distribution of rewards would look much different if modern technology did not admit such large economies of scale, but it is by no means obvious that society as a whole would be better off without it.

"The sums earned by first- and second-rank stars today are sources of envy and disgust in some quarters and give rise to mumblings about crass commercialism and the evils of cutthroat competition. In my view, a more balanced perspective is possible once one understands how technologies that sustain such sums have at the same time reduced the relevant real pr ice and cost of these services to consumers to remarkably small proportions compared with earlier days.

"Bringing back the good old days of restrictive reserve clauses and stock-company movie star contract systems surely would reduce the incomes of those stars. It just as surely would simply transfer the gains to club owners and producers because it would do nothing to eliminate the fundamental sources that support them. Because of the technology and the demand, the money is there; the only question is how is it to be divided up."

"How it is to be divided up" is precisely Ricardo's question.