Arnold Kling  

Trends in Relative Earnings

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Do Grad Students Really Swagge... A Hazy Question...

Ian Dew-Becker and Robert J. Gordon write,


Only the top 10% of US earners have seen their incomes grow faster than productivity since 1966. Part of the top-earner income growth is driven by market forces (superstar economics); the only feasible pro-equality policy here is more progressive taxation. For top corporate executives, however, non-market forces (CEO-Board complicity in pay setting) are important, so other policies are warranted. Increased disclosure and improved corporate governance would distribute economic gains more evenly across society and boost firms’ value.

I wrote about superstar economics when I talked about billers and players. People who are compensated by the hour are billers. People who play in winners-take-most tournaments (fiction authors, athletes, would-be CEO's, high-risk entrepreneurs) are players.

I think it is possible that Dew-Becker and Gordon are correct that high CEO pay reflects exploitation of shareholders by CEO's. But there is at least one alternative story, which is that high CEO pay is an inducement to would-be CEO's to perform loyally and effectively.

That is (I think this is Edward Lazear's model), suppose that upper middle managers have only limited incentives to remain loyal and to perform optimally. However, they are participants in the tournament that determines who will be the overpaid CEO. The incentive to win that tournament induce better performance on the part of upper middle management than the other incentives.

For this story (and probably other stories) to seem plausible to me, you have to invoke diminishing marginal utility to rewards. That is, the reason that I can't just offer a bonus to my chief marketing officer to get him to perform is that he has diminishing marginal utility of income. So I have to offer a huge marginal bonus. Any way I do that is going to spread the income distribution. But one way to offer a huge marginal bonus is to say that good performance increases the probability of getting promoted to CEO and being vastly overpaid in that position.

So one of the factors in the widening income distribution is diminishing marginal utility of rewards at the top. In income terms, the high pay is unbelievably high. In marginal utility terms, the additional income is not worth so much.

If that story is true, then the authors' reforms won't work. Corporate transparency won't matter, because companies need to offer large marginal income rewards to upper management in order to get top performance. And higher marginal tax rates won't work, because they will just force corporations to raise pre-tax compensation in order to get the same after-tax marginal incentives.

My preferred outcome would be the gradual demise of huge corporations, brought on by ruthless competition from smaller firms. I think that the CEO tournament produces a lot of dysfunctional behavior in addition to whatever constructive incentives it provides.


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CATEGORIES: Income Distribution



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The author at The American Mind in a related article titled Economics Links–06.20.08 writes:
    Two former Bear Sterns hedge fund managers were arrested for fraud. [via Free Exchange] Brad Setser sees the rise in oil prices and the dropping value of the dollar as due to a relatively sluggish U.S. economy. Total workers’ compensation (not s... [Tracked on June 20, 2008 3:56 AM]
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John Thacker writes:

The second explanation that I've heard is that rising CEO pay at the largest corporations is related to the increased size of the largest corporations. Of course, that explanation still leaves room for Dew-Becker and Gordon to argue that it is the result of CEO's getting compliant boards to approve inefficient mergers.

Brandon writes:

"non-market forces (CEO-Board complicity in pay setting)"

I'm confused why they think CEO compensation is a non-market force?

Are Drew-Becker and Gordon not aware that:

A) Boards are elected by shareholders
B) Shareholders, even if overruled, can vote with their wallets and sell stock that's underperforming due to perceived CEO overcompensation?

Their proposal is a bait and switch. They're identifying a market-based salary as non-market based, and in order to supposedy make it more "market-based," they propose regulations and taxes that will make it less market-based.

shayne writes:

Arnold:

Your "player" and "biller" analogy is interesting, but the entire debate of CEO (or other executive management) compensation/overcompensation is wrong-headed and founded in jealousy rather than any interest in equity or equality.

The fundamental economic principal affecting executive management compensation is scarcity. The number of people who truly understand wealth, how to create it, distribute and manage it, on an instantaneous let alone an ongoing basis is extremely small. Note that the wealth these people create has to be in both of two forms: (a) in the form of Return On Investment for the shareholders, and (b) in the form of produced goods and services that make people's lives better. That talent or capability is extraordinarily rare and thereby commands extraordinary compensation.

For those who argue that executive management compensation is too high, or that the skills/talents I mentioned above are not that rare, I suggest they give wealth production - in both forms - a try themselves. As Adam Smith pointed out, wealth production only takes land, labor and capital, and the planet has an abundance of each. It is only the skill of managing those elements that is wanting.

Steve Jobs, a highly compensated CEO, when asked by an interviewer once what advice he would give to folks who want to make a million dollars replied (I'm paraphrasing here), "Those people really don't want to MAKE a million dollars. What they really want to do is SPEND a million dollars." Quite frankly, the folks who argue that executive management compensation is too high are just folks who want to SPEND a million dollars, and there is no scarcity of them.

randy writes:

it was nice to say you desire to see the "gradual demise of huge corporations". i see so much waste and inefficiency in those workplaces, it astounds me.

i just wonder though, given economies of scale, how this would ever happen without some sort of awful revolution-type event.

shayne writes:

To randy:

Exactly what sorts of "waste and inefficiency" are you observing in large corporations? The reason for my question is that in my consulting and teaching, I see far more waste and inefficiency in small and mid-sized firms. In nearly every case of troubled small and mid-sized firms, applying many of the same management techniques and approaches pioneered and applied by large firms solves problems and restores viability.

As an aside, I don't advocate the demise of the large firm/corporation, but I do strongly advocate the "ruthless competition from smaller firms". For example, anyone can compete with Wal-Mart - even the "mom and pop" shops. It's just enormously unclever to think one can compete with Wal-Mart within the cost-leadership strategy regime that they have perfected. That is not to say that competing firms (small or large) can afford to be wasteful or inefficient within a differentiation strategy and survive.

loki on the run writes:

If you believe in ruthless competition between corporations, then surely you believe in ruthless competition between workers as well, or, if collective bargaining is good for employees then surely ...

Mr. Econotarian writes:

I'd like to suggest the theory of CEO pay presented towards the end of Steven Levitt's TED talk "Why do crack dealers still live with their moms?"

http://www.ted.com/index.php/talks/view/id/29

In a nutshell, the heads of drug gangs always make big money, even when there is a market downturn in illegal drug sales. The reason is because the gang leaders don't want to be seen as "weak and sh&t"...

Libra writes:

One very unreported factor is the rise of "dumb" money in the system. If I partake in my company's 401K plan, I get a substantial tax break for investing, but I'm limited to a list of 10 Fidelity mutual funds. How are those mutual funds chosen? How did Fidelity get in the enviable position of being the beneificiary of this huge tax break? If they got it through political means, rather than proven ability, then we have no reason to suspect that the mutual fund managers will be competent watchdogs of corporate management.

Most 401K's and pension funds have strict rules about the companies they can invest in. Many have to invest in index funds or something closely approximating the S&P 500. What incentive does a company in the S&P 500 have to improve, if mutual funds have to invest in them?

The entire S&P 500 has become a collectible. IE- something with no intrinsic value that is only valuable because everybody else believes it is valuable. The general price level of the S&P 500 will rise as the monetary base expands. A 401K is tax free way of buying an appreciating collectible. Given the overpricing or Real Estate and commodities, and the negative interest rates on bonds, simply keeping up with inflation might be the best an investor can hope for.

I wouldn't be surprised if in a few decades the dividend rate had dropped to 0% and the P/E ratio was up to 50/1. There's simply no reason for upper management not to pillage the company to pay their bonuses. If the stock is a collectible, the actual earnings do not matter. Unforunately, the earnings matter a great deal to the wealth of a nation. Thus in the longer run, the trend has to end, or we will end up in economic ruin.

TGGP writes:

Kevin Carson claims that much of the hierarchy and advantages enjoyed by big corporations over smaller competitors is due to the State in The Freeman here.

Michael writes:

Would it not also be worth remembering that "the top 10%...since 1966" is not an actual group of people? The people who constitute "the top 10%" can shift from day to day, month to month, and year to year -- to say nothing of what happens over the course of four decades.

dearieme writes:

"because companies need to offer large marginal income rewards to upper management in order to get top performance": why? Wouldn't the threat of firing the beggars work well, and more cheaply too?

Snark writes:
The number of people who truly understand wealth, how to create it, distribute and manage it, on an instantaneous let alone an ongoing basis is extremely small.

Which explains why there is very little turnover in the global management ranks of highly-compensated CEOs, even amongst those who under-perform. It’s a Catch 22.

For those who argue that executive management compensation is too high, or that the skills/talents I mentioned above are not that rare, I suggest they give wealth production - in both forms - a try themselves.

It’s certainly a risk I’d be willing to take, considering the reward for failure is typically a multi-million dollar annual salary, excluding incentive bonuses for poor performance. It would be like an amateur boxer stepping into the ring with Mike Tyson. Take the 1st round KO and the loser’s purse and live happily ever after.

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