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					Are CEOs Overpaid?--Posner

The media are full of stories about the compensation of chief executive officers of
American companies. The theme of the stories is that CEOs are paid too much.

The economics of compensation are fascinating. In the simplest economic model, a
worker, right up to the level of CEO, is paid his marginal product--essentially, his
contribution to the firm's net income. But simple observation reveals numerous
departures from the model. For example, wages vary across the employees of the same
rank in the same company by much less than differences in their contribution to the
company, and employees who do satisfactory work can expect real (that is, inflation-
adjusted) annual increases in their wages throughout their career with the firm, even
though their contribution will not be increasing at the same rate, and eventually not at all.

Let us see what sense can be made of the curious pattern of CEO compensation.
American CEOs make much more on average than their counterparts in other countries--
about twice as much. You might think that this was because Americans at all levels earn
more than their foreign counterparts, but this is not so; the difference between U.S. and
foreign wages is much smaller below the CEO level. In other words, wages are more
skewed in favor of CEOs in American companies. The disparity is related to the fact that
salaries are a much smaller fraction of American CEOs' incomes (less than a half) than of
foreign CEOs' incomes, with the rest consisting of bonuses but mainly of stock options.
Both the fraction of CEO income that is nonsalary, and total CEO income, have been
rising, dramatically in the United States, over recent decades. But there is a recent
tendency of foreign CEO compensation policies toward convergence with the American
practice.

One can speculate about the causes of some of these differences. Stock options and other
incentive-based compensation methods impart risk (variance) to CEOs' incomes, which
reinforces the risk inherent in the fact that a CEO's human capital (earning capacity) may
be specific to his firm, so that if he lost his job because his company had been doing
badly (perhaps for reasons beyond his control), he would take a double hit--lower pay as
the company declined and lower pay in his next job. Because business executives (as
distinct from entrepreneurs) do not like risk, they demand a higher wage if the wage is
going to have a substantial risky component. This may explain some of the difference
between American and foreign CEO compensation, but surely not all or even much of it--
especially since job turnover at the CEO level is actually greater in Europe than in the
United States.

Another possible difference is that stock ownership tends to be more concentrated abroad
than in the United States. The more concentrated it is, the more incentive shareholders
have to monitor the performance of their firm's managers because they have more at
stake. The more effective that monitoring is, the less need there is to create incentive-
based compensation schemes: the stick is substituted for the carrot.
Cultural factors may be important. European countries in particular are more egalitarian
than the United States, suggesting that envy is likely to play a bigger role in
compensation there. Astronomical ratios of CEO to blue-collar wages in the same
company cause little resentment in the United States compared to what they would cause
in Europe, though wide disparities between workers at the same level does engender
resentment here even if the disparities track differences in productivity.

Envy might reduce average incomes at the same time that it reduced variance in incomes,
if the more generous compensation of American CEOs merely reflects the greater
contribution that they make to their companies' success. But there are two reasons to
doubt this, and thus to suspect that American CEO incomes are padded to some degree.
First, the most significant "incentive" component in these incomes--stock options--are not
well correlated with the CEO's contribution to the value of his company and thus of the
value of its stock. Many things move a company's stock besides the decisions of its CEO.
To tie a CEO's income to the value of his company's stock is a bit like tying the salary of
the President of the United States to the U.S. GNP.

Second, the choice of stock options as the principal method of providing nonsalary
compensation to CEOs seems related to the fact that traditionally the income generated
by these options, unlike salary or bonus income, was not reported as a corporate expense.
Of course security analysts and stockholders large enough to follow closely the affairs of
the companies in which they invest can calculate the expense of stock options, but the
ordinary public cannot, and this is important because even in the United States envy is a
factor that can influence policy and public opinion. A spate of recent articles has
explained the ingenious devices by which CEO compensation that would strike the
average person as grossly excessive is concealed from the public, and these articles,
along with well-publicized corporate scandals, may place some downward pressure on
CEO compensation. Companies cannot afford to ignore public opinion completely,
because adverse public opinion can power legislative or regulatory measures harmful to a
company or an industry.

It might seem that, provided the shareholders--the owners of the company--are made
aware of the actual compensation received by the CEO, competition will drive that
compensation down to approximately the level at which the CEO is just being paid his
marginal product, with appropriate adjustment for risk. But given the size of companies,
the cost to a major company of even a grossly overpaid CEO is so slight when divided
among the shareholders that no shareholder (assuming dispersed ownership) will have an
incentive to do anything about that excess expense.

What about the board of directors? Their incentive to minimize what from the overall
corporate standpoint is only a minor cost is also weak, and may be offset by rather minor
economic and psychological factors. The board is likely to be dominated by highly paid
business executives, including CEOs, who have a personal economic interest in high
corporate salaries and a natural psychological tendency to believe that such salaries
accurately reflect the intrinsic worth of their recipients.
Becker in his comment on this post (below) cites an interesting paper by Gaibaix and
Landier which argues that the increase in CEO compensation is a function of the growth
in the market value of firms. The basic idea is that the CEO of a more valuable firm is
more productive, since if he increases value by say 1 percent the increase in absolute
value will be greater the more valuable the firm is. If there are two equally skilled
managers and one manages a grocery store and one manages IBM, the manager of IBM is
probably creating greater value.

The theory is too new to evaluate with any confidence. I am somewhat skeptical because
rapid increases in CEO compensation should attract more talent to management, and the
resulting greater competition for CEO positions should dampen the increase in
compensation.

An alternative explanation for the correlation between firm value and CEO
compensation, one that is consistent with the evidence that such compensation is often
excessive from an efficiency standpoint, is that the greater the firm's market value, the
easier it is to "hide" the compensation of the top executives. Suppose that a 10 percent
increase in value is associated with a 3 percent increase in CEO compensation; then the
percentage of the firm's value that is going to the CEO will have fallen. This may be one
reason why many mergers fail to increase earnings per share, although the overall value
of the enterprise will be greater after the merger (there will be more shares): the increase
in overall value enables the CEO to increase his compensation regardless of whether he
will be creating greater value as the manager of the larger enterprise.

Posted by Richard Posner at 09:23 PM | Comments (19) | TrackBack (1)

Are CEOS Overpaid? BECKER

The answer to the question of whether American CEOS are overpaid is clearly "yes" for
those who earn large bonuses and generous stock options when their companies are doing
badly, either absolutely or relative to competitors. Business Week has had an annual list
of the most overpaid CEOS relative to the performance of the companies they head. A
number of well-known companies usually top that list.

But the concern in the media and in Congress over CEO pay is not motivated by some
bad apples like these, but by the huge increase in the typical CEO pay in the US during
the past 25 years. The total real compensation (that is, compensation adjusted for
increases in the price level) of CEOS in larger publicly traded companies during this
period grew a remarkable six fold, where compensation adds together regular pay,
bonuses, stocks awarded, the value of stock options, and payouts from longer term pay
programs. A big but not the only component of the increase is due to much greater use of
stock options. Since median fulltime real earnings during the same period only just about
doubled, the gap between pay at the top and the average pay of employees widened
enormously. It is hard to resist the widespread perception from these trends that CEOS
and other top executives are being increasingly overpaid.
The case against the pay of American CEOS looks even more powerful by recognizing
that the typical American company head receives greater total compensation than
company heads in Great Britain, Canada, Japan, Spain, and in pretty much all developed
countries. Clearly, American CEOS are much better paid than CEOS elsewhere, even
when per capita incomes of the countries do not differ by very much.

Yet competition for top management can explain the rapid rise over time in the pay of the
average American CEO. To understand how competition works in the management
market, consider the strong and stable relation at any moment between the total
compensation of CEOS at publicly traded companies, and the size of the companies they
head. For every 10 per cent increase in firm size, measured by the market value of assets,
by sales, or by related variables, compensation increases by about 3 per cent. This "30 per
cent" law held during the 1930's, and has held for every succeeding decade, including
right up to the present. Note that stock options and other forms of compensation than
salaries and bonuses were unimportant until the 1970's, so this relation is not due to the
rapid growth of options and compensation through shares of stock.

The usual explanation given by economists for the positive relation between
compensation and firm size is that the largest companies attract the best management.
Therefore, bigger companies have to pay their CEOS better in order to discourage them
from going to head smaller companies. It is also socially efficient to have the best
mangers run the largest companies because their greater skills then have a bigger
influence since they would manage a larger amount of labor and capital. The efficient
combining of better managers with larger companies in a competitive market for top
managers would imply a positive relation between firm size and the total compensation
package. This analysis does not explain why the 30 per cent rule holds, but it suggests
that the relation between pay and size is likely to be sizable, even when top management
in different sized companies do not differ greatly in skills and abilities.

We need two additional facts to explain the sharp rise in pay over time, and the much
higher pay in the United States than other countries. The first is that the average size of
large American companies has grown in real terms about six fold during the past twenty-
five years, regardless of how "large" is measured, as long as the same measure is used
consistently over time. The other important fact is that the largest 50, 100, or 500
American publicly traded companies are much bigger than the largest companies in other
countries.

Clearly, if large companies pay more, and if the average size of companies has grown
sharply over time, average compensation would also grow, even if the value of the
increasingly generous granting of stock options and equity shares were fully understood
by stock markets and boards of directors. It is also possible to understand why average
compensation grew about as rapidly as average company size, although the argument
here is more complicated (for the details of this argument, see Xavier Gabaix (MIT) and
Augustin Landier (NYU), "Why Has CEO Pay Increased So Much?" unpublished, April
17, 2006). The allocation of better managers to larger firms, and competition for these
managers among companies of different sizes, means that companies in say 2006 would
have to pay more for their CEOS than even the same sized companies did in 1980,
although much less than six times as much. The reasoning is that the 2006 companies of a
given size are competing against relatively larger companies than comparable size
companies did in 1980. Using this analysis, Gabaix and Landier are able to explain why
total compensation of the average CEO of larger companies grew about six fold along
with the six-fold growth in average company size during the past several decades.

The same argument explains why compensation of American CEOS is much higher than
that of CEOS in other countries. Since average firm size is much lower elsewhere, their
pay would be more like that of pay in the US in 1980 or 1990 than the pay of CEOS in
today's much larger American firms. As the market for top executives becomes
increasingly global, the pay of CEOS in other countries would rise, and that of CEOS in
America might fall. For example, to attract Carlos Ghosn, a Brazilian working in France,
to turn around Nissan, a seriously ailing company, Nissan had to pay him not at the low
Japanese CEO levels, but at the much higher levels found in other countries.

I believe that the explanation based on the allocation of CEO talent largely is behind the
explosion in compensation of American CEOS during the past several decades. Yet at the
same time, some American CEOS are obviously grossly overpaid since they have
mismanaged their companies, and still receive exorbitant compensations. But
mismanagement is not new and probably has not become so much more important over
time. So I am suggesting that the rapid growth of compensation of American CEOS, and
its premium over compensation of CEOS in other countries, is not mainly due to a growth
in the degree of excess payment of executives in the United States. Rather, on this
interpretation, the main cause of the increase in pay is the greater challenges and
opportunities facing executives who manage much larger combinations of resources.

				
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