Responding to an earlier post of mine, the very smart Ian Dew-Becker emailed me the following text:
I saw you had a post up about some work I did with Bob Gordon, and I found your comments very interesting. I have a couple questions that I hope might help clarify your thoughts on the subject.
First, you seem to argue that we would expect a CEO to be paid her marginal product. As you point out, there is ample evidence that a CEO adds far more to the value of a company than she is generally paid. I’m curious, though, what you mean when you say we would expect the CEO to be paid her marginal product. Models in this literature often assume that each firm must hire one CEO. The concept of a marginal product breaks down at this point. The firm can’t hire a second CEO. There is no marginal value. It’s possible that we can look at marginal products in terms of the skill a CEO brings to the firm, but in that case, we would be mixing up marginal and average products if we were to simply look at the total contribution a CEO makes to firm output.
I think you’re correct to point out the institutional factors holding down CEO pay pre-1970. That said though, why didn’t we see CEO pay rising much faster than market cap during the 80′s in order for it to catch up to where it should be? There is a period where the pay-market cap elasticity may have been higher than 1, but it’s only for a few years in the 90′s. Looking at the full 1976-2005 sample, the relationship is nearly unitary (.935, according to Frydman and Saks). So I guess I’m surprised there is no catch up in pay.
I think you’re right to be skeptical of the Bebchuk-Grinstein results. To me, the most interesting result from Gabaix and Landier, no matter what one thinks about their model as a whole, is that the cross-section and time series may show very different patterns. So one wouldn’t necessarily expect the cross-sectional results from Bebchuk and Grinstein to predict the time-series.
One of my biggest concerns with Gabaix and Landier’s model is that it does not display decreasing returns to scale. An analogous example is Berk and Green’s model of mutual funds. They assume that if a manager all of a sudden sees the size of his fund double, he will see lower average returns. I think this is reasonable. When there are not diminishing returns, it is difficult to make models function. Gabaix and Landier are forced to do it by assuming firms never merge. That concerns me in this setting. Dixit-Stiglitz competition is often a reasonable assumption because the models using it do not actually care about firm size or mergers. In the case of CEO pay, however, firm size is clearly critical.
The question about the marginal product of a CEO is a tricky one. I can imagine the following definitions which either express marginal product or some modified version thereof:
1. How much better the highly-paid guy is than a less-well-paid substitute would be.
2. How much better the highly-paid guy is than the next best person (in stochastic terms, that is) the firm would get for that same sum.
3. How much a bit of extra pay causes the CEO to improve effort and thus performance.
4. The complex econometric definition offered by Jensen and Murphy, read pp.33-38 here.
5. Some number between the CEO’s value of leisure and how well the firm would do with no CEO at all.
None of these quite make sense in pure theory, and it is even harder to say which is the most important variable for practice.
I think this could benefit from the Sabermetric literature on VORP. i.e., how much better would the CEO be than a “replacement-level” CEO? I dunno how to build a measurement of “replacement-level” CEO quality, but I don’t think it would be impossible.
Marginal product only makes sense for direct labor compensation that appears as a part of marginal output cost. What is the marginal revenue product for a tax accountant?
A CEO’s compensation is, and must be, determined by the market. Choosing a CEO is a highly risky gamble, and the variability of future results mandates the hiring and retention of the highest ranked candidate since even the highest compensation of an honest, successful CEO is insignificant and an amazing bargain from the POV of the shareholders. With an unsuccessful, or dishonest CEO, compensation is likely to be the least of shareholder concerns.
Regards, Don
dearieme,
“That’s a good argument, Don, if the shareholders get to choose the CEO and determine his pay. But I’ll bet they don’t.”
No, but either the Board of Directors is effectively acting as agents for the shareholders or they’re not. If they are, fine. If they’re not, in large enough nembers, then the market price for CEO’s may be triple what it would be otherwise due to the presumed incestuous relationship between CEOs and Directors. But reducing the market pay level of CEOs by 3X would still be of little import to the bottom line of shareholders.
Regards, Don
Not being willing to re-read the 50+ page Murphy treatise on Exec Comp, I would say that most boards use something like definition 1 or 2. They’re considering that the difference between the best and next-best guy is worth something on the order of two-to-five percent return on capital, with significant discounting for the uncertainties surrounding that estimation. The compensation of today’s CEOs don’t come close to rewarding that value of the marginal difference in talent, meaning the discount for uncertainty is (necessarily) very high.
As someone who develops compensation contracts, I can attest to three things:
1) CEO comp in the real world much more complicated than almost any of the social critics can imagine (admittedly, most of them don’t have much imagination)
2) Most boards are extraordinarily conscientious about CEO pay, which undermines the Bebchuk-Grinstein explanation and prescription, premised as it is on managerial power
3) The Gabaix and Landier explanation is on the whole a better fit with reality, in part because of their assumption of constant returns to scale, although I disagree with their model of “CEO talent.” I have not yet seen a good theory for modeling “CEO talent.”
“They’re considering that the difference between the best and next-best guy is worth something on the order of two-to-five percent return on capital,”
You do realize that 5% return on capital is the maximum expected return on capital going forward?
You were joking when you said you were involved in drawing up compensation contracts?
Also, a lot of shareholders (index funds for instance) will own shares in competing companies, so a gain for company A will come at the expense of competitor B.
Why is Ian only talking about female CEO’s? I don’t see anything in this argument unique to that gender.
Stockholders calculate their gains/losses on market cap, and return on book value or assets is only informative about companies prospects. Fama and French estimated that about 1/3 of the returns on stock over the last 50 years have been due to the fall in the discount rate which is unlikely to be repeated. Therefore estimates of future returns using past data are likely to be too high by that amount, so 5% is a reasonable guess for stockholder returns. However the price book ratios are rarely one, so the 2 to 5 percent on return on capital must be corrected for the price book ratio to see what the return of a top CEO is to stockholders. It is this number that should be compared to the effect of the permanent 5% decrease in profits and market cap that was the result of the doubling of executive pay.
DR PETER TEIMAN FRANKLIN here,
Ceo compensation packages have alwas mystified me.
DOCTOR PETER TEIMAN FRANKLIN
Sweden
I’ve read that private equity firms typically pay CEOs more than public firms do. If true, that pretty much destroys the Bebchuk theory that CEO compensation is due to lax boards and the agency problem for dispersed shareholders.
Seer, I think you’re seriously confusing incremental returns for a specific company and average returns for the whole market (which is not what I was talking about).
You also chose to ignore what I said about boards discounting the expected incremental contribution of a CEO, which means they would award significantly less than incremental 2 to 5 percentage points they might be supposed to contribute. But that is a second order error compared to the first I mentioned above.
If you must respond to something I wrote, please respond to what I wrote, and not what you think I wrote.
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