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« Baggage Economics | Main | The Carbon Cutting Quandry »

Why do CEOs Make so Much Money?

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.

Topics: Labor Economics, Economics |

3 Responses to “Why do CEOs Make so Much Money?”

  1. Blake Wentworth Says:
    September 25th, 2008 at 6:30 am

    Dear Chris,
    How do explain the present economic situation where it seems all the CEO’s of the financial community have failed? What would your solution be

  2. Rob G. Says:
    March 12th, 2009 at 6:43 pm

    I love when people rationalize ceo pay. It is a fact that they take on the big picture. They direct the company to sucess or failure. They also are highly educated or at least most of the time. What I do not understand is the wide pay gap between the senior executive staff, junior executive staff, and the management under that. Generally speaking, there is a few making millions, a hand full making 6 figures and the rest are under 60k a year. I’m not arguing that the cleaning staff make 100K a year but the wealth allocation is one sided. That ceo is not worrying about the next pay check. There is probably enough money in the account to make a living from interest. The other thing is ……………..who gives a SH*T that they work 80 hours a week. Many people work 2 to 3 jobs to just make ends meet. Unfortunately, opportunity was not available for the high end business or law schools that are mostly party now and get high paying jobs because of connections. So what that some and I mean some people think they are highly intelligent. Engineers are intelligent. Scientists are intelligent. You may say that a ceo is also highly motivated. Let’s see a ceo make it through a science, medical, or engineering degree. Oh well that requires many hours of study and hard work. Most doctors work long hours and “really” have people’s lives in they’re hands. Doctors pay is not even close to ceo pay. It’s not just the pay that is bs, it is all the perks that go with it. In and out whenever, dinners, golf outings, and oh damn I need to host a executive outing to a sports venue. Yes they have more responsibility than most but the compensation far exceeds the responsibility. Do I believe success should be rewarded? Most definitely. Not to the extent it is now and definitely NO GOLDEN PARACHUTE!!!!!!!!!!!! The other point I’d like to make is that most ceos will never opt to reduce their own compensation………ahh let’s cut 1/4 of our employees first. Basically, they all need a major check to the glass. I could go on and on……. and yes pro athletes, actors, and musicians are overpaid too. Society is just dumb enough to pay their price.

  3. David Says:
    March 25th, 2010 at 7:11 pm

    How the CEO came to make 10 times as much money as the other employees

    It was a warm spring morning in Oakwood Forest, and entrepreneurship was in air. Bear and Fox decided that today would be a good day to start a company.

    Bear hired ten squirrels for his company and made one of them CEO. He paid both the worker squirrels and the CEO squirrel one acorn per day. Fox did the same thing, hiring ten squirrels (nine workers and one CEO) and paying each of them one acorn per day.

    Business was split equally between the Bear’s company and Fox’s company.

    Business continued as usual, until one day Fox had a brilliant idea. He decided to pay the CEO squirrel 10 acorns per day. The CEO squirrel didn’t do any more work than he used to. He just got fat. But the other squirrels started working like crazy! They came into work early, ate lunch on the job, and worked late into the night. Some of them slept at the office. Others stopped going on vacation. All of their squirrel spouses grew quite upset and most of the squirrels working at Fox’s company had sad squirrel divorces. All to have a better chance of being picked as the next CEO. But business was booming and Fox’s company, with its highly productive worker squirrels, drove Bear’s company out of business.

    This is called “Tournament Theory” and it explains why CEOs (and Partners, upper management, etc.) are paid so much more than average employees.

    Moral: pick your own acorns.