Arnold Kling  

Thinking About CEO Pay

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Tyler Cowen writes,


Keep in mind that we are already juggling a few margins here, including "getting this CEO to work harder or better" and "this CEO vs. another."

Read the whole thing, as well as his previous post. Some remarks:

1. A corporate CEO's pay is determined by how well he or she manages two entities: the company; and the board. If you manage your board well, you can manage your company poorly and still make a lot of money. (Alex Tabarrok agrees.) Conversely, I thought that Leland Brendsel managed Freddie Mac pretty well, but several years after I left he got ousted by the board in an accounting "scandal" that consisted of holding down accounting earnings to more closely reflect economic earnings. His successor, Richard Syron, managed the board well, but he was a disaster for the company--and for the whole financial system.

2. I think that Tyler's reasons for skepticism about measuring the marginal product of a CEO are applicable to many, if not most, employees in a modern business. Recall the Garett Jones characterization of workers as producing organizational capital, not widgets. CEO's have a lot of influence over the organizational capital development of their firms. When you have an entity as big as a Fortune 500 company, slightly better approaches to developing organizational capital can make billion-dollar differences in value.

The concept of marginal product assumes a sort of mathematical continuity that just isn't there in the real world. The textbook representation of business decisions as solutions to calculus problems is grossly misleading. In an actual business, you don't have an equation for your demand curve. You don't have a cost function.

3. I think of CEOs as players in a tournament. Their performance reflects both skill and luck factors. Their pay reflects both their performance and still other luck factors.

4. I suspect that the relationship between pay and value for CEO's falls far short of the standards of cosmic justice. But I suspect that even coming up with those standards is far beyond anyone's capability.


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CATEGORIES: Business Economics



COMMENTS (12 to date)
mark writes:

Those are four really insightful points, although on the fourth you cut yourself a lot of slack. I would only add a 5th: Asymmetry. A bad ceo (or, to be more neutral, a ceo who experiences bad luck, or a good ceo who tries to save a company that for secular reasons is doomed) pays nothing when results are poor. In that context, it is hard to justify the fat tail positive returns some CEOs get. Often those returns are functions of factors beyond his or her control such as declining interest rates, loose credit, etc. And the data that people look at to evaluate this question often do not include all the companies with net negative returns during a CEO's tenure. Were those added, the ratio of CEO pay to enterprise value returns might look a little higher.

joeftansey writes:

CEOs and other large managers have multiplicative synergy with the company. I.e. if a regular employee does his job well, his job gets done better. If a CEO does his job well, everyone's productivity increases.

This same pattern is followed in other multiplicative improvements. Specialized computer programs, consultants, etc.

SWH writes:

I am reminded of the words of a long time angel/VC investor reflecting on his last years of working with startup companies. He said that he learned two things: 1)success is all about identifying good management and 2) it is almost impossible to identify good management.

Noah Yetter writes:

It would be more accurate to say that you don't know the equations of your demand curve or cost function. They still exist, even if only in some sort of quantum probabilistic sense.

Navin Kumar writes:
I think that Tyler's reasons for skepticism about measuring the marginal product of a CEO are applicable to many, if not most, employees in a modern business. Recall the Garett Jones characterization of workers as producing organizational capital, not widgets.

Surplus value. Har har

Jeff writes:

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fundamentalist writes:
“I suspect that the relationship between pay and value for CEO's falls far short of the standards of cosmic justice.”

Actually, the only standard of justice for CEO pay should be the one set by the Salamancan scholars in the 16th century. Scholars of the Church spent centuries studying the criteria for a just price, including wages. They determined that just wages exist if the transaction is voluntary on both sides and no fraud exists.

One of the main reasons that people complain about CEO pay and not the pay of pro athletes, actors or rock stars is that they don’t understand what CEO’s do. What athletes, rock stars and actors do is obvious to everyone. But as one student said in class, CEO’s don’t do nothing; they hire other people to do all of the work.

A lot of academics add to that image of the CEO by claiming that business success is all luck. Of course, much of that is due to the fact that academics think they are the smartest guys in the world so CEO’s shouldn’t make any more money than them; if they do they don’t deserve it.

One of the greatest failings of mainstream economics is the lack of understanding of what CEO’s and entrepreneurs do.

fundamentalist writes:

Noah:

“It would be more accurate to say that you don't know the equations of your demand curve or cost function.”

I agree. I have created both for companies and find them very useful. Every company must forecast sales. Many simply ask salesmen what they think. Others merely add 5% to last year’s sales if they’re optimistic. The very best companies use some form of regression with price as one of the variables and that creates a demand curve. In the same way, the best companies forecast costs based on independent variables and that creates a production function for them. The best companies have a good idea of what price changes will do for sales. In fact, I would say that the use of such analytics separates the best companies from the worst. For more see the book “Supercrunchers”.

Gepap writes:

fundamentalist wrote:

One of the greatest failings of mainstream economics is the lack of understanding of what CEO’s and entrepreneurs do.

Except CEO's are NOT entrepreneurs for the most part. They are managers. They don't start enterprises, they come in once that business is working already.

Comparing CEOs to athletes is a good comparison - ahtletes are generally penalized with lower pay when their productivity, which is extremely easy to measure, declines over time. They win less, and can claim smaller salaries or no longer claim any salaries anymore. No sports star can consitently lose for their team and claim to be doing great. They don't get golden parachutes. How can any manager that steered their company to bankruptcy, or high falls in sales, claim thay they deserve added compensation? Yet they do.

That Dick Fuld is still massively rich and not in the poor house is the best indictment of fundamentalist's beliefs.

fundamentalist writes:

Here are a couple of quotes from a 2005 paper from Babson Executive Education, “Competing on Analytics” that was featured in the Harvard Business Review:

“Instead of looking backward at their business performance and making ex post facto adjustments, they seek to understand how optimum nonfinancial performance drives optimum financial performance, and to make accurate forecasts of future performance so they can react in advance of situations.”

Translated, that means they create demand curves, usually separate ones for each product line.

In financial performance analysis, they create complex models of how their operational and cost measures relate to their financial performance.”

These are production functions.

www.babsonknowledge.org/analytics.pdf

fundamentalist writes:

Gepap, in the first place, CEO’s don’t determine their own salaries; the board does. CEO pay expresses what board members think of the CEO position and the person in it. To say that Fuld didn’t deserve his pay is to say that board members don’t know what they’re doing. Fuld’s compensation was determined when the board hired him. The board thought he was worth the price. The board understood that Fuld would receive the contracted pay regardless of how well the firm did and that they would fire him if he performed poorly.

In the second place, boards probably don’t place all of the blame for failure, or give all of the credit for success to the CEO. Boards have a good idea of how much the CEO contributes to the company’s success, but recognize that some things are outside the CEO’s control. For example, investment banks failed when housing prices collapsed. Do the CEO’s of investment banks determine on their own the value of housing? Could they accurately forecast the collapse in the value of housing when neither the Fed no any PhD economist in the nation did?

No, comparing CEO’s to athletes is a terrible comparison. A wide receiver has a very specific job – catch the ball. It’s very easy to tell if a receiver misses the ball because the QB threw a bad pass or because the receiver just dropped it. A sports analogy for a CEO would be the coach. Coaches have contracts and when they get fired for having losing seasons the owner doesn’t try to bankrupt the coach. Most leave with a huge severance package.

What you want to do is turn the CEO into an entrepreneur. But to do that, you would have to get the CEO to agree to accept nothing but stock as his compensation. Not many CEO’s would take that and they don’t have to because there is so much competition for good CEO’s.

Warren Bentley writes:

A manager's job is to work through people, and by that work accomplish the needs of the organization, bond the people into a durable team, and develop those people to be better at their own jobs.

As a general rule, the most important of these three for a CEO is to get and coach and develop her direct subordinates to be better managers themselves. The should become so good they either get hired away, or she has to pay them a significant fraction of what she herself gets paid in order to keep them. If she is not doing this, she is not doing her job. The same is true of all her subordinates.

This is what is wrong with superstar CEO's. The symptom is their directs are getting too small a fraction of what they get. If a $100M (million) boss has directs getting only $10M after three years, she is not doing her job. If they get $50M but nobody is being hired away, she is still not doing her job.

On the other hand, if she were doing her job, her directs would be at $70M after about five years in grade, and one or two out of six would be hired away in those five years.

All boards are collectively managers, and any board that allows this superstar nonsense to continue is not doing its job either.

(/end of rant)

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