By Chris | August 14, 2008
Fortune 500 CEOs are constantly criticized for their excessive salaries. Over the last few decades their wages have been rapidly rising while the median wages have been stagnating. See the graph that illustrates that:
“In 1965, U.S. CEOs in major companies earned 24 times more than an average worker…Since then, however, CEO pay has exploded and by 2005 the average CEO was paid $10,982,000 a year, or 262 times that of an average worker ($41,861).”
This trend is disconcerting to many people. A very close friend of mine told me that his soon to be in-laws advocated regulations capping CEO pay at a multiple of a company’s entry level salary. This issue is very emotional because many people can’t comprehend how someone deserves 11 million dollars a year when others working full time can’t afford health care.
Here are three explanations I’ve come across to explain high CEO pay:
1. CEO pay acts as a prize to motivate everyone in the organization to strive to work their way up the corporate ladder. This argument was presented by Tim Hartford in The Logic of Life. It is the same train of thought that explains why kids in the inner city sell drugs on the street for less than minimum wage. High executive pay gives everyone in an organization an incentive to work their hardest to get to the top.
2. CEO pay reflects the marginal product of savvy strategic decisions. Smart decisions by CEOs can mean the difference between millions of dollars in profits or losses. The use of options as a mechanism to compensate executives (despite its flaws) represents an effort to pay CEOs in proportion to the value they add to a corporation.
3. High CEO pay is the result of shareholders mistakingly attributing positive performance to CEO skill rather than random noise (luck). Nassim Taleb argues in Fooled by Randomness that executives make a small number of large decisions. Because the sample size is so small, it is very difficult to tell if a successful CEO is talented or just lucky. In Taleb’s words:
“CEOs make a small number of large decisions, more like the person walking into the casino with a single million-dollar bet. External factors, such as the environment, play a considerably larger role than with the cook. The link between skill of the CEO and results of the company are tenuous. By some argument, the boss of the company may be unskilled labor but one who presents the necessary attributes of charisma and the package that makes for good MBA talk…There are so many companies doing all kinds of things that some of them are bound to make “the right decision.”
I don’t think that Taleb gives CEOs enough credit. CEOs aren’t given their position, they have to earn it. They often do so by succeeding multiple times on a smaller scale: by running a profitable team, then a department, and eventually a division. These managerial roles require many small decisions and the likelihood that repeated successes are the result of chance is quite small. Nevertheless, I can’t help but agree with Taleb that it is in our nature to attribute skill to success stories that are often the fueled by external factors. As an undergraduate business student, Southwest was constantly lauded as a model airline with a sound business strategy. In reality, it made one lucky bet on oil and hasn’t been operationally profitable for years.
Overall, I find #2 as the most convincing, albeit simplest, explanation of CEO pay. However, when a CEO is making a few big bets, shareholders can be comforted in the knowledge that even if they are overpaying an unskilled CEO, at least they’re encouraging everyone else to work harder.