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Intrinsic Inefficiencies in Executive Pay October 25, 2009

Posted by federalist in Human Markets, Markets, Unions.

Can every CEO be above average?  Obviously not, but when a shareholder’s board is responsible for hiring and compensating an employee there is a structural defect, perhaps best summarized by Jonathan Macey:

No self-respecting board of directors is willing to admit that their company’s CEO is below average. So anytime the new disclosures indicate that an executive’s pay is below average in any way, a pay increase is ordered.

The board is responsible for representing shareholders’ interests.  They would be abdicating their duties if they retained a substandard executive, so unless they’re either resigning their seat or firing a CEO they practically have no choice but to assert that he is above average, and to pay him accordingly.  This leads to an “arms race” of sorts with respect to executive compensation, and the race can become completely detached from efficient labor markets.

If labor markets were efficient then executive pay would be set based on the supply of competent executive candidates and the demand for their labor.  Demand would be limited by the marginal value that a “good” versus “not-as-good” executive could create in a business.

However, the dynamics of a representative board can overwhelm this microeconomic model.  As Rick Bookstaber suggested in a recent post: the board may not be able to quantify or predict the marginal value of an executive.  But that’s their job, so whether they have actually quantified the value of an executive — whether it is even theoretically possible — they behave (perhaps subconsciously) as if they are doing their job, which means they have retained exceptional executive talent.  And the only way to confirm that — to themselves, to the executive, and to their shareholders — is to give their executives above-average compensation!  So every board has to look at what every other board has chosen to pay comparable executives, and then they have to raise it.  The only escape valve for this cycle is for compensations to get so clearly out of line with fundamental supply and demand of executive labor that a majority of shareholders not only see the disconnect but also become sufficiently energized to shake up the board.  And as we know the threshold for large-scale shareholder activism is a high one indeed!

Note that this dynamic is not unique to executives or public companies.  Governmental boards — e.g., school boards — often fall into the same compensation arms races with neighboring districts.  Unions also exploit the arms race dynamic to inflate their wages by negotiating contracts, not on the basis of supply and demand for their labor, but on the basis of keeping up with some reference group (ideally one also engaged in the same arms race).



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