CEO Pay

I stumbled across the economics working paper Why Has CEO Pay Increase So Much? in late February:

This paper develops a simple equilibrium model of CEO pay. CEOs have different talents and are matched to firms in a competitive assignment model. In market equilibrium, a CEO’s pay changes one for one with aggregate firm size, while changing much less with the size of his own firm. The model determines the level of CEO pay across firms and over time, offering a benchmark for calibratable corporate finance. The sixfold increase of CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large US companies during that period. We find a very small dispersion in CEO talent, which nonetheless justifies large pay differences. The data broadly support the model. The size of large firms explains many of the patterns in CEO pay, across firms, over time, and between countries.

The paper presents a ‘simple’ equilibrium model for CEO pay based on firm size. It’s certainly simple in theory, but I confess to stumbling a trifle when it came to the math.

I chose the paper to present to my 200-level Microeconomics Theory class, which I will do this coming Monday (10/22/2007).

If you have time, I recommend reading at least the introduction. If you don’t, allow me to summarize, in brief:

The paper uses the simplifying assumption that the market for CEOs is competitive; namely, that (1) CEOs have talent and companies can measure that talent (or, at the very least think they can estimate it pretty well), (2) CEOs impact firm value in some measurable way, (3) there are no industry-specific CEOs (e.g. the Harvard/McKinsey assumption), and (4) the market for CEOs is frictionless.

They demonstrate that most of the increase in CEO pay can be attributed to the increase in firm size – at least in the USA. This makes sense from a conceptual standpoint: assume that the impact a CEO has on a company is a percentage. The absolute value of a CEO’s contributions will depend directly on the size of the company; a larger company will receive a greater direct effect. If a company gives a percentage of the absolute gains in corporate value to the CEO as compensation, a CEO’s compensation will increase as firm size increases.

The truly interesting claim they make – based on empirical data – is that CEO compensation exhibits constant returns to scale in regard to firm size. There may be fluctuation in the short term, but over the long term CEO compensation will directly correlate with company size.

The paper doesn’t address – or try to – the entire increase in CEO pay. They also acknowledge that they are unable to make any concrete assumptions about international markets, mainly because the data is limited. Even assuming that everything in the paper is true, we still can’t know whether or not this is a US-specific phenomenon. This did not, for example, occur in Japan.

I like the paper, because it’s a good example of economics explaining a phenomenon without making moral judgments about how the world ‘ought’ to be. And, of course, if the paper is torn apart in peer review and later literature it’ll merely confirm the reputation of economists.