ceo pay and theories of income
A well known fact about CEO pay is that it has increased in absolute and relative terms. Provided by the Stanford Center for the Study of Poverty and Inequality, the chart shows that CEO pay has exploded relative to the earnings of average workers in manufacturing or production.
There’s been a lot of debate about why, but less discussion of what that says about our theories of income. My view is that this is evidence against a straight up Becker/human capital view and evidence for the segmented labor market/political view on income. According to the human capital view, personal income, roughly speaking, is a return on the investment in your skills. So if your skills are in high demand, your income goes up. If that’s true, in a relative view, demand for CEO has gone up astronomically in comparison to the typical worker. It’s easy to see why worker income has not gone up – globalization of the labor market, for example – it’s hard to see why CEO pay went through the roof. Is it really true that CEO skills became extremely scarce? Or that their marginal product shot up, and remained high, over the last few decades? Maybe…
The alternate view is that income is set by politics. The aggregate income generated by an industry may be set by consumer emand, but the way it’s distributed within firms and industries is political. As multiple folks have noted, like Jerry Davis, Neil Fligstien, and Greta Krippner, firms began to rely more and more on finance for income, which is the result not only of financial technology, but also policy. There was a lot more money in firms, but very little way to distribute it down the chain.
Interesting post. With respect to the human capital perspective, CEO pay is extremely difficult for both boards and shareholders to price. A lot is going on at any given time that could be affecting earnings.
In my view, the rise in CEO pay has been driven by another dynamic: Rather than seeking to optimise return on investment, companies compete with each other for CEOs with a certain skill-set who are already well-compensated at other large business. To get a recognized good CEO, you have to pay them at least what they’ve made in the past or what other good CEOs are making.
There is a kind of risk-aversion to this approach. Companies don’t want to miss out on whatever this person does by taking a ‘value’ option. They also fear talent going elsewhere, and having a celebrated CEO is a kind of reward in itself for a lot of companies. Together, this means that the price pressure is almost exclusively upward in the CEO labor market. It tends to be one-way notch. The only real restraint on what a company would pay for a proven CEO appears to be the company’s ability-to-pay.
Your point about policies has to be correct too. Corporate governance rules have helped facilitate this. There’s conflicting data, but some people believe that giving shareholders a greater say on pay would charge things. Others have argued that shareholders are just as susceptible as boards to the pricing problem. There are a lot of proposals (caps, tying pay to different performance measures, etc.), but it seems like the pay disparities will persist until there’s a way to build downward price pressures into the CEO labor market.
Anthony
July 21, 2011 at 3:12 am
Fabio, how do square your argument with the evidence provided by Steve Kaplan (Academy of Management Perspectives, 2008) that other highly skilled professionals, such as hedge fund managers, attorneys, and top athletes, has increased by about the same percentage as that of CEOs? This suggests that the phenomenon has little to do with corporate governance, the “power” of the finance sector, etc., but higher marginal returns to skills, driven by industry demand and scarcity of top talent.
Peter Klein
July 21, 2011 at 4:27 am
I think it just makes sense that as people run bigger firms their marginal product goes up. Combine this with the economics of superstars (Rosen 1981) and increasing CEO pay is pretty much explained; Gabaix and Landier (2008) find empiricially that increases in firm size can completely explain increases in CEO pay for the last 30 years.
James
July 21, 2011 at 12:18 pm
DiPrete et al. (2009 AJS) have a convincing paper that CEO pay skyrockected because of a compensation boards pegging pay to comparison competitor’s pay. The rub was that CEOs defined who the comparison CEOs were, and always choose alters with higher pay, producing a game of income leap frog. My recent work with Ken Lin shows that CEO compensation did rise more rapidly in (non-finance) firms that pursued finance, rather than production, investments. Capital share of income and income inequality among workers both rose as well in response to financialization. We see the mechanism as a weakening of labor’s claim to income as they become less central to investment strategies.
Don Tomaskovic-Devey
July 21, 2011 at 3:14 pm
Neither of those accounts seems particularly compelling to me. See DiPrete et al for the best analyis of the subject that I have seen:
Compensation Benchmarking, Leapfrogs, and the Surge in Executive Pay
Thomas A. DiPrete, Gregory M. Eirich and Matthew Pittinsky
American Journal of Sociology
Vol. 115, No. 6 (May 2010), pp. 1671-1712
http://www.jstor.org/stable/10.1086/652297
ezrazuckerman
July 21, 2011 at 3:24 pm
i’m generally a big fan of complementary productivity models and all that, but i agree with Ezra and Don that the rachet effect model has a lot going for it. also see Khurana for a more qualitative/thick account. my only reservation about it is that to the extent that we think the rachet is signaling (ie, nobody wants to show themselves to have gotten a CEO at Crazy Eddy’s Discount Executives) then we’d expect the rachet to be more pronounced at publicly traded than private equity companies and i’m not sure if this is empirically true (or even how we’d find out given that the data is much better for firms that have to do SEC filings — presumably you could infer it by seeing the best executives switch sectors but there’s a lot of measurement error and a small n).
gabrielrossman
July 21, 2011 at 4:56 pm
Don: Looks like we were cross-posting. I look forward to reading your paper when you’re ready to share.
Gabriel: Doesn’t the DiPrete et al logic already make the public vs. private firm contrast salient without adding in your story about signaling (it’s about governance failure in public firms)?
ezrazuckerman
July 21, 2011 at 5:09 pm
I like the Diprete et al piece. But what about Gabaix and Landier 2008, Quarterly Journal of Economics
“Why has CEO pay increased so much?”
Charles Seguin
July 21, 2011 at 6:13 pm
Oh, should’ve read the comments above before posting…
Charles Seguin
July 21, 2011 at 6:17 pm
Since you mentioned him, Gary Becker on increasing CEO pay here:
http://www.becker-posner-blog.com/2006/05/are-ceos-overpaid-becker.html
Wonks Anonymous
July 21, 2011 at 9:45 pm
The arguments made about how CEO pay has risen along with that of hedge fund managers, etc., so THEREFORE it is about return on skills and performance is a NON SEQUITUR. firms in other countries which perform well have lower CEO pay than that of US firms. I propose a Dean Baker-type solution: obviously CEO’s in America are inefficient, their pay has no correlation with the performance of their firms – we should import lots of CEO’s from Japan to work for a fraction of the price
Andrew
July 22, 2011 at 4:10 pm
From the post: ” It’s easy to see why worker income has not gone up – globalization of the labor market, for example – it’s hard to see why CEO pay went through the roof.”
I would say that perhaps part of the reason for the widening of relative pay difference is captured right there in the original post. Worker income increases have been suppressed (actually, regressed in some cases) by globalization while CEO pay has not. Most US companies, for example, would be hard pressed to believe a CEO who has the skills to operate in an environment like, say S. Korea or Poland is likely to have the right skills to operate in the US (though they very well may). One obvious concern is that their success may simply be heavily due to the “luck” of having cheap labor. And if they are to replicate that in the US it translate to off-shoring, and US CEOs already have that “down pat.”
Robert
July 27, 2011 at 2:38 pm