Are CEOs paid too much? To most economists, that question does not involve fairness, justice, outrage or any of the other terms that many people use regarding pay in the millions of dollars. Instead, they focus on whether the sums paid to CEOs do or do not exceed the value that these individuals add to their firms.
The economic question is whether or not CEOs of major corporations simply earn a market-clearing wage determined by the supply of, and demand for, talented individuals. If yes, then no one is being “cheated” by high pay. If no, then what factors allow CEOs to capture above-market earnings?
The question is not a settled one. But the consensus is moving toward the “market failure” rather than the “market clearing” end of the spectrum.
Take that assessment with a grain of salt. On questions that excite public attention, the views of a majority of economists plus $1.50 will get you a double latte at your favorite espresso joint. Moreover, diagnosing market failure is the easy part. Designing responses that fix the situation, rather than cause greater harm, is far more difficult.
Historically, economists tended to believe that in a situation of apparent competition — there are plenty of executives who would like to lead businesses — CEO pay reflected supply and demand.
From the beginnings of economics, scholars focused on monopoly as the primary way that markets fail to produce efficient outcomes. Over time, economists looked for other circumstances when optimal outcomes might not materialize. They found several, including two that apply to CEO compensation issues.
One situation in which free markets can lead to bad outcomes is when people making economic decisions have bad information. The free-market-as-a-societal-optimum model always rested on an assumption that all decision-makers had pretty good, if not perfect, information.
It became clear that when information was lacking or when it was asymmetric, with one side in a deal having much better information than the other, the resulting market outcome was often bad for society as a whole.
Another set of circumstances in which markets could fail was when there were “principal-agent” problems. The “principal” is the person whose economic well-being is really at stake. An “agent” is the person a principal hires to manage his or her resources on a day-to-day basis. This might be a farm manager administering an estate for an absentee landlord or a CEO managing a corporation for the stockholders.
For years, economists assumed that hired agents carried out their tasks as if they were principals. A farm owner naturally would manage his farm so as to maximize the present value of its earnings over some period of time. If he died and his widow hired a manager to run the place, that manager would act exactly as the owner would have.
This was a simplifying assumption, but obviously it frequently was not true in real life. So younger economists began to explore what would happen when hired managers or “agents” began to run businesses to maximize their own well-being rather than that of the business’ owners.
“Information problems” and “principal-agent” problems are not mutually exclusive. Agents frequently are able to feather their own nests at the expense of the principals who hire them precisely because information is asymmetric. The farm manager or CEO knows more than the farm owner or stockholders and carefully controls the flow of information to these principals.
CEOs still trumpet the “free-market clearing pay” model arguing they are just getting paid for the shareholder value they add and under which if they were paid a penny less than what they are getting, someone else would immediately snap them up with a more lucrative offer.
Virtually all economists are skeptical. It is clear to most of us that there are market imperfections in contemporary CEO compensation. The degree of CEO influence over corporate board members, the hiring of “compensation consultants” and the frequency with which CEOs sit on each other’s boards are well documented. Where economists do differ is on how serious the problem is and about what measures, if any, should be taken to correct the problem.
Wage earners may be outraged if their employer’s CEO earns 400 times what they average. But the corporate shareholders are the true principals who are getting hurt and they should be the first to take action.
Enron and other recent corporate scandals demonstrated that there are plenty of problems in U.S. corporate governance. How CEO pay is set is only one component in a set of institutional failures.
Unfortunately, there are no easy answers. We need to make corporate managers more responsive to the needs of shareholders. But in recent decades we have moved to a financial system where few people own stocks directly and thus few have any incentive to take action when CEOs abuse shareholders.
Large institutional investors are crucial to any reform. If they fail to find ways to better represent the interests of their members or clients, an angry public may force government to act. What the outcome of that might be, no economist knows.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.