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New theory on fairness in economics targets CEO pay
Date:11/3/2009

the economic interpretation of the concept of entropy.

"There have been many attempts to find a suitable interpretation of entropy for economic systems without much success," Venkatasubramanian said. "Just as entropy is a measure of disorder in thermodynamics and uncertainty in information theory, what would entropy mean in economics?"

Venkatasubramanian identified entropy as a measure of "fairness" in economic systems, revealing a connection between statistical thermodynamics, information theory and economics.

"As we all know, fairness is a fundamental economic principle that lies at the foundation of the free and efficient market system," he said. "It is so vital to the proper functioning of the markets that we have regulations and watchdog agencies that break up and punish unfair practices such as monopolies, collusion and insider trading. Thus, it is eminently reasonable, indeed reassuring, to find that maximizing fairness, or maximizing entropy, is the condition for achieving economic equilibrium."

Using the new theory, the ideal pay distribution is determined to be "lognormal," a particular way of characterizing data patterns in probability and statistics.

"This is the economic equivalent of the Boltzmann distribution for ideal gases, which describes how the gas molecules are distributed at various energy levels," Venkatasubramanian said. "One may view our result as an 'economic law' in the statistical thermodynamics sense. The free market will 'discover' and obey this economic law if allowed to function freely and efficiently without collusion-like practices or other unfair interferences."

The publication comes at a time when Congress is grappling with the issue. The Federal Reserve announced a plan on Oct. 22 to eliminate excessive pay packages that might encourage bankers to take reckless risks. The Obama administration pay czar, Kenneth R. Feinberg, has announced plans to reduce executive pay at compan
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Contact: Emil Venere
venere@purdue.edu
765-494-4709
Purdue University
Source:Eurekalert  

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