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Update on CEO pay
Mark Thoma cites some new research on inequality and CEO pay, challenging the Gabaix and Landier result that CEO pay has risen broadly with the stock market. The main criticism is that the result does not hold pre-1970...
Gordon and Dew-Becker refer to "outsized" increases in CEO pay but scant attention is paid to the broader literature or to event studies. You don't have to go as far as Jensen and Murphy (1.4 cents received for every $1000 of value created) to see that CEOs don't capture the full value of their contribution to the corporation, or anything close to it. Read this survey, pp.33-38 in particular. That is, even in today's "Gilded Age" successful CEOs are underpaid relative to their marginal product, or how much they affect the value of the firm.
What about pre-1970? The obvious interpretation is that "way back when" CEO compensation was held very low, relative to marginal product, by social conventions (and perhaps to some extent by the threat of law, especially in the 1930s and 40s). Once these social constraints were relaxed, CEO pay rose very broadly in step with the stock market. The elasticity of CEO pay, with respect to performance, has been rising sharply.
The citation of institutional factors may sound like a criticism of Gabaix and Landier, but nothing in their paper denies the influences of such forces. They simply point out a recent regularity between the value of what is controlled and how much one gets paid to control it. It's a trivial point, but it stops being trivial when people start forgetting it.
We shouldn't expect the elasticity of CEO pay to market capitalization, over most stretches of time, to be close to one, even if it is close to one for some time periods. I would expect fairly long lags at times and then lots of catch up, with an elasticity greater than one for those catch-ups; the data seem to show this. The CEOs, however productive they may be, are reaping rents relative to their leisure, and their ability to capture those collective rents need not fit any particular time path. (That said, when you do see a 1-1 ratio it makes perfect sense.) The data do indicate that a regime switch has led to much greater rent capture, bringing compensation closer in line with CEO marginal products but still falling short of marginal products.
So in my view the Gabaix and Landier results holds up quite well, especially if one is willing to admit the central role of cultural factors, pre-1970 or so, in limiting CEO pay.
I'm not persuaded by the Bebchuk-Grinstein result that observable factors explain only about half of CEO pay; in fact I am surprised that the observables explain as much as they do.
Here is more from Mark Thoma. Here is a post from Ezra Klein on same.
While I disagree with some of their interpretations, the Gordon and Dew-Becker paper is a very useful summary of much of the literature on income inequality.
Posted by Tyler Cowen on September 6, 2007 at 10:18 AM in Economics | Permalink
Comments
. . . successful CEOs are underpaid relative to . . . how much they affect the value of the firm
Are these studies really attributing all created shareholder wealth to the CEO? That hardly seems justified.
Posted by: Archit at Sep 6, 2007 11:14:21 AM
archit beat me to the punch. How exactly, or even approximately, do you measure the CEO's marginal product?
By the way, Murphy's "refutation" of the idea that compensation committees and consultants are pawns of the CEO is interesting. He talked to them, you see, and and they denied it.
Posted by: Bernard Yomtov at Sep 6, 2007 11:19:16 AM
The studies don't assume what you are alleging, for their methods see pp.32-33 of the Murphy survey plus of course the pieces themselves. Isolating the CEO's contribution is a difficult problem but under plausible specifications they remain way underpaid relative to marginal product.
Posted by: Tyler Cowen at Sep 6, 2007 11:35:45 AM
Tyler, I'd take you more seriously if you could explain why CEO's never hand back compensation when profits or marketcap declines. Marginal product cuts both ways.
Posted by: seer at Sep 6, 2007 12:41:23 PM
Finally. Someone looking out for the little guy.
Posted by: Underpaid CEO at Sep 6, 2007 12:52:24 PM
Well, one thing is sure- a bad CEO can cost shareholders far more than the pay the CEO receives.
While I think shareholders could exercise more control over their companies than they do, and that CEOs are largely overpaid, I still have yet to see a really good justification for getting government involved in setting CEO pay ceilings. If the justification is that CEO are simply overpaid, then this same, open-ended justification might be used to set pay ceilings on employees of far less well-compensated workers. I just don't think it wise to cede such power to bureaucrats, especially those I think are overpaid themselves.
Posted by: Yancey Ward at Sep 6, 2007 1:35:50 PM
"Tyler, I'd take you more seriously if you could explain why CEO's never hand back compensation when profits or marketcap declines. Marginal product cuts both ways."
seer,
I'm no economist, but I'm guessing they don't give back comp because they like money.
As for why their contracts don't require such forfeiture, probably because:
a. It would make CEOs too risk-averse, which is one of the big problems that modern compensation packages try to avoid; and
b. In order for CEOs to accept a substantial chance of having to pay back 8 or 9 figures of compensation (after they've already used it to buy a house or a plane), you'd have to pay them even more money, on average.
Posted by: Robert Beard at Sep 6, 2007 3:04:29 PM
If you believe that compensation should be based on marginal product, assuming you can calculate it, then how do you think Bernanke should make: $100M?, $1B?, $10B?
Posted by: seer at Sep 6, 2007 3:24:36 PM
10 Cents?
Considering 0.0016 to be significantly different from the error term is always interesting.
Robert Beard - If they've used it to buy a house or a plane, then how is that different from when I declare bankruptcy and everything gets repossessed?
Posted by: Ken Houghton at Sep 6, 2007 3:40:24 PM
I've never understood why options indexed to the performance of competitors stock price (over about 10 years) aren't used as the primary form of executive compensation. This way you're paying for out performance while separating out the index drift that has been responsible for most of the compensation increases of the last several decades. Institutional investors want to beat their index over the long run, and that will align executive compensation with that goal. At the money options don't.
Posted by: nelsonal at Sep 6, 2007 5:51:55 PM
"I'm not persuaded by the Bebchuk-Grinstein result that observable factors explain only about half of CEO pay; in fact I am surprised that the observables explain as much as they do."
I read this as saying:
"No, we have absolutely no idea why CEOs make as much as they do"
which is a few logical leaps from:
"There is no reason why we shouldn't tax CEO pay either, as we cannot establish a direct link between CEO pay and CEO performance in the short-run"
Posted by: Robert Olson at Sep 6, 2007 8:12:18 PM
I'm trying to think of pretty much any other sector where pay has anything to do with the value of the thing being controlled. Air traffic controllers? Nope. Couriers? Nope. Pilots and drivers of all kinds? Nope. Surgeons? Not really.
Hollywood and professional sports are the only places I can think of where stars even nominally get paid in some kind of proportion to overall enterprise size. And those are also areas where the people on the other side of the negotiation have strong incentives to offer high pay, because having highly-paid stars contributes (almost per se) to the success of the enterprise. (You see a variation of this kind of delusion in the book industry, where a large advance guarantees a large marketing effort, if only because the alternative would be unthinkable.)
Posted by: paul at Sep 6, 2007 9:58:47 PM
Isolating the CEO's contribution is a difficult problem but under plausible specifications they remain way underpaid relative to marginal product.
Prof. Cowen, as far as I can tell, neither the Murphy overview nor the Jensen & Murphy articles from 1990 (in Harv. Bus. Rev. and J. Pol. Econ.) discuss any attempt to isolate the CEO's contribution to performance from the contributions of other managers and employees. The net-of-market corrections don't address this problem. That said, the paper you linked to yesterday ("Do CEOs matter?" by Bennedsen, Perez-Gonzalez, Wolfenzon) certainly suggests that the CEO as an individual matters quite a bit.
Posted by: Archit at Sep 6, 2007 10:18:28 PM
The use of market caps instead of profits weakens the argument because at least 1/3 of the increase in stock market over the last 30 years have been due to(changes in P/E) falling interest rates, not company performance, (Fama & French) and the effect of the change of rates is not uniform across firms.
I am also not clear what marginal product means when applied to unique positions in a firm. One definition would be the additional value added compared to the pay of the next most competent person for the job, which would be the result of competition. The compensation of the top 5 executives of a firms get on average 10% of the profits as compensation. Prior to the 1980's they got 5%.
If a CEO is has a personal tragedy he is probably not even close to the most competent person for some time afterward. The Danish study shows that good management matters, but not how much firms need to pay to get it. If everyone one the assembly line had a child die the productivity of a firm would probably fall more than 15%.
Posted by: joan at Sep 7, 2007 2:31:40 AM
Posted by: kkmedia at Sep 7, 2007 2:32:51 AM
Re:paul
I would say those professionals are paid on a basis of the revenue they add to the organization. If you think of a pilot, along with all the support personnel, as a marginal unit, the marginal unit be about equivalent to the marginal revenue from one more flight an airline receives in a competitive environment.
Same goes for surgeons or anybody else except for the government-supported union type jobs. Firms don't pay lawyers 300 dollars an hour just because they feel like it; it's because they offer a service that's worth the money we pay them.
Posted by: Matthew at Sep 7, 2007 2:59:33 AM
[How exactly, or even approximately, do you measure the CEO's marginal product?]
and more fundamentally, what do you do about the aggregation problem - that when you've isolated everybody's marginal products, the sum of them will typically be much larger than the total amount?
Posted by: dsquared at Sep 7, 2007 6:48:05 AM
"I'm trying to think of pretty much any other sector where pay has anything to do with the value of the thing being controlled. Air traffic controllers? Nope. Couriers? Nope. Pilots and drivers of all kinds? Nope. Surgeons? Not really."
I think the top surgeons in the U.S. receive much higher pay. Certainly those surgeons selected to test new devices and techniques for medical corporations are well-compensated. My wife has worked with a couple of them.
Plastic surgeons who have convinced the public of their higher skill levels - and who can bring in more revenue from "star" patients - earn more than those working at charity hospitals.
Pilots of larger aircraft receive significantly higher pay. They are not providing a a higher quality of service. They have no control over the revenues the airline will realize. But more "responsibility" does equate to more pay.
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