Month: October 2007

CEO compensation and the marginal product of the CEO

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.

The New Invisible Competitors

That is the title of my piece in the new Wilson Quarterly, not on-line anytime soon and yes you should subscribe.  The piece looks at how people emotionally respond to the move from neighborhood, face-to-face competition to competition at a distance, or what I call invisible competition.  Some people will fare better in this new environment than others; for instance people who rely on adrenalin to compete will find it harder to motivate themselves in this new and more impersonal environment:

The greatest gains in this new world are likely to go to people who are methodical planners or who love the game for its own sake. Some people plot their competitive strategies far in advance. These planners–be they crazy or just highly productive–don’t need anyone breathing down their necks, and indeed they often work best alone or in very small groups. Bill Gates is a classic example. Planners’ behavior may manifest itself in very competitive forms, but their underlying psychology is often not very rivalrous at all. They are ordering their own realities, usually for their individual psychological reasons, rather than acting out of a desire to trounce the competition. Early risers will also be favored. These people enjoy being first in line, or first to use a new idea, for its own sake.

Of course many of us miss face to face competition, so we try to recreate it in trivial ways, sometimes using our children:

As the concrete manifestations of the more important contests of love and business vanish, we recreate up-close rivalry to make our lives feel more real. I suspect that this helps explain the growing appetite for televised athletics and organized sports for children as well as the vogue for reality TV series such as Survivor and American Idol, eating contests, and even spelling bees. Because children are a cheap labor supply and willing to engage in all sorts of behavior for a chance at a prize or parental approval, they often serve as the vehicle for parents who seek to live out their desire for head-to-head competition vicariously. Spelling, for example, does not interest many people (who sits around practicing?), but bees exemplify the competitive spirit in action. The challenge to spell autochthonous, panmyelopathy, or warison will bring one kid to tears and another to triumph.

Worst-Case Scenarios

That’s the new book by Cass Sunstein, and yes it works through how choice theory should approach disasters and irreversible events.  It is the most accessible presentation of this material to date and it is recommended to anyone who follows issues of global warming, pandemics, asteroid impacts, and the like. 

The concluding chapter opens with the old quotation:

"If you make a plan, God laughs.  If you make two plans, God smiles."

When it comes to this book, the worst case scenario is that you are out $24.95, you despair at mankind’s ability to actually address these problems, and you come away enlightened.  I would have wished for more material on public choice issues — how good a job can governments do with these problems? — but the more salient point is just how much Sunstein does cover.

Eric Lyon on Radiohead

I think Radiohead has
everything going for them except their music. Radiohead initially came
to my attention after they sampled Paul Lansky’s "mild und leise" (an
excellent early computer music composition, available on Lansky’s
website) for their song Idioteque. Paul likes what they did with his
sample much more than I do. I find the drum track weak in comparison
with DnB practice which was so much further along by the late 90s, and
the voice is plaintive, thin, lacking all conviction. Radiohead looks
good on paper, a fusion of modern techno-derived computer music
techniques with rock music, but in practice, the tunes are
uninteresting, and the sound production is unexceptional. Another one
of many post-MBV disappointments that understand the ideas but not the
spirit of My Bloody Valentine. I don’t enjoy criticizing Radiohead
because they clearly mean well, and their music is carefully and
thoughtfully assembled. But they just don’t deliver brilliant musical
goods, and I’m somewhat puzzled by their mass success. But I am pleased
by it. It’s nice to see rock intellectuals getting serious attention.
And their recent Internet marketing experiments deserve attention, just
for trying something different. But I’d take the Pale Saints’ fully
realized "The Comforts of Madness" over any Radiohead album, by a very
large margin.

My Secret Fear

My secret fear is that one day I will find myself working in Starbucks; the cashier will call out orders – double latte frappuccino, no whip, extra hot, tall; iced caramel macchiato grande; pumpkin spice crème with soy… I will become confused and disoriented, was that extra whip or no whip?  Tall or grande?  Soy or no soy?  What am I doing?  People will shuffle their feet impatiently, check their watch and stare at me with disdain as I struggle to keep up.  I will start to sweat – now people are frowning.  Aaarrgghh – take me back to my quiet office!

I try to remember my secret fear when the conversation at lunch turns to IQ and yes I tipped extra today.

What’s your secret fear?

MR Readers’ poll about Radiohead

How much did you pay?  Just let us know in the comments, and those of you who wouldn’t otherwise answer, please answer and help us defeat selection bias at least in part.  Just as the heroic Tim has done (please see the second comment), I’m sure he stands up to terrorists as well.

And it’s simple: just cook the cheeseburger in milk, what’s so hard about that?  Do note the burnt milk will ruin any good pan you use.  If you’d like to read some Doris Lessing, The Golden Notebook is compelling even though it is one of those books which old school feminists feel no man can possibly like.  Just be wary of the date who tells you it is his all-time favorite book.  I’ve never been persuaded by Lessing’s science fiction but some of you will wish to try it.

My Favorite Things Maine

I don’t know this state very well, so I fear that this list is not, in fact, my favorite things from Maine.  It is what I think are my favorite things from Maine:

1. Writer: The first five volumes of The Dark Tower are amazing plus I love The Stand and Misery and The Dead Zone.  He’s not as good as Melville or Faulkner but few other American writers beat him.

2. Painter of seascapes: He’s not from Maine, but surely he counts because he painted there.  Try this one, or this one.

3. Painter: Marsden Hartley, this one is atypical.  There is also Andrew Wyeth, do you know the old saying "As usual, the truth lies somewhere in between"?

4. Poets: There is Longfellow, E.A. Robinson, and Edna St. Vincent-Millay, none of whom I much relate to but nonetheless I am impressed in the aggregate.

5. Best writer about spiders and swans: Duh.

6. Movie director: John Ford, with Stagecoach, The Searchers, and The Man Who Shot Liberty Valance as the classics.

7. Composer: Walter Piston is the only one I can think of, try this disc.

8. Beautiful woman: Liv Tyler.  Wasn’t she beautiful?  But when?  I can’t find any picture on Google to prove it…

The bottom line: For an isolated, underpopulated state, this is a pretty awesome line-up.  But hey, it’s cold up here!

Random rants

Most of all he has rotten diction (odd for a former actor), plus he had no idea what the market-oriented crowd wanted to hear.  Sell short.  I’m still predicting Giuliani; Hillary will do worse once the attack dogs gear up.  The fascinating but overlong Into the Wild is about, among other things, the weaknesses of family ties in the United States, and how people seek artificial family in response.  In a free society people must, to some extent, put principles of justice and political order above loyalties to clan.  This is why the idea of a free society attracts so few Russians, and also why their quasi-liberalizations have not been pretty.  The new Charles Taylor book is one of the best (implicit) responses to Greg Clark; it shows how radically a societal worldview can change over time and also why belief in God is no longer taken for granted.  Tell Me You Love Me keeps getting better and soon I will try the Yglesias-recommended Friday Night Lights.  Don’t be fooled by the good reviews for Michael Clayton, nothing is there conceptually.  I want to see more Michael Powell movies (is he today the least-known-most-important major director?), starting with Colonel Blimp.  I finally "get" what other people see in John Adams’s Violin Concerto.  No, good frying pans really don’t hold up for long and yes I have started cooking my cheeseburgers in milk.

The last three items I bought at Best Buy all were broken upon first inspection. 

Books John Nye should read

Since the 1990s the policies of the three major players (Taiwan, China, and the United States) have become unstable in many ways.  The possibility of a miscalculation by any participant with respect to the two others is quite high.  China thinks that Washington will not sacrifice Los Angeles for Taiwan, the United States that Beijing will not sacrifice twenty or thirty years of development for Taipei, and Taiwan that it can confront Beijing with a fait accompli and not suffer the consequences.  Those are three dangerous mistakes.

That is from Therese Delpech’s fascinating Savage Century: Back to Barbarism.  This book made a splash in France but has been virtually ignored in the U.S.  There haven’t been many reviews but here are some endorsements.

Two of the book’s major themes are a) don’t be fooled, the barbarisms of World War II and 20th century totalitarianism are not really behind us, and b) don’t expect Asia to be stable in the 21st century.  Highly recommended and yes it did remind me of John Nye.

Speaking of John, here is a Reason dialogue with John, covering his new book and also his description of GMU lunches.

Paul Krugman, pussycat

The Conscience of a Liberal is um…not that polemic.  It’s not that shrill.  There is an argument, to be sure, but the book has much more economic history than I had expected, and much more political history.

I’ve already blogged on The Great Compression; Krugman’s more detailed account in the book does emphasize the role of war, wage and price controls, and very high rates of taxation.  Normative questions aside, Krugman’s positive analysis isn’t as far from mine as I had been expecting from his blog post.

Some claims in the book are simply wrong: "…if there’s a single reason blue-collar workers did so much better in the fifties than they had in the twenties, it was the rise of unions."  (p.49)  Of course it was instead greater capital investment per head and better technology; if Krugman means relative status he needs to say so.  This conflation of relative and absolute magnitudes is a running problem throughout the first part of the book.

Most of all, today’s world — or even an extrapolated version thereof — isn’t nearly as like the Gilded Age as Krugman suggests.  Absolute standards of living really do matter, and most Americans today live very fine lives, or if they don’t the economy is not at fault.

Krugman writes of "the vast right-wing conspiracy" repeatedly, and in these moments he verges on the shrill.  But Bush receives virtually no attention; perhaps Krugman is simply sick of writing about the guy

Conservatism rose in the 1980s in large part because the mid to late 1970s were such an economic mess and because American had lost so much relative status internationally.  Krugman won’t face up to that; instead he blames the Republican manipulation of "the race card," even though at the time racial tensions arguably were lower than ever before.  Of course in a relatively close election any single factor can be called decisive but I found this discussion well below the standards of the political science literature, even the popular political science literature.

Krugman calls for single-payer health insurance, tax hikes, and raising the minimum wage.  He doesn’t come off as all that radical.

His theory of government failure is that wealthy right-wingers hijack the state to redistribute wealth to themselves, and that’s all we hear on what’s wrong with government.  That’s the part of the book I find hardest to swallow, but if you’re asking "should I read this?" the answer is yes.

My prediction: For lack of red meat, this book won’t sell nearly as well as Naomi Klein’s latest.  At my Borders, circa 4 p.m., they hadn’t even unpacked it.  "Yeah, we have that in the back somewhere, I haven’t seen it yet." was what the guy said.

My question:  Is Paul Krugman willing to come out and simply pronounce: "Margaret Thatcher turned the UK around and for the better"?  If so, how does this square with his broader narrative?  And if not, why not?

Addendum: Here is Ed Glaeser’s review.

Nobel Prize for iPod

I think what is most interesting about today’s Nobel prize in physics is how quickly the discovery of a new effect, giant magneto-resistance, led to real devices including the iPod.  From the totally unknown to the utterly familiar in less than twenty years.  The world really is speeding up.

The Nobel Prize Foundation has a very nice write-up of giant magneto-resistance and its applications.