Why do CEO’s make so much money? The question seems to obsess us, probably more than it should. Discussions of income inequality often turn to the topic of outsized CEO pay packages, even though massive payouts to a handful of people cannot possibly account for the trends we have seen in the nation’s income statistics—there simply aren’t enough CEOs of large companies to produce the change, even if every one of them received outsized compensation, which isn’t the case. Similarly, CEO pay is often brought up in the context of stagnating median wages, even though the pay of most CEOs, distributed across thousands of workers, would boost their paychecks by only a small amount.
Nonetheless, inside most of us retain the village instinct that anyone who is paid so much must be getting away with something. In the fourth chapter of his new book, the Logic of Life, Tim Harford suggests that we’re right. Sort of. But not necessarily in the way that you probably think.
A lot of the invective against CEO pay is simply argument from incredulity: how could Michael Eisner possibly be worth $800 million in total compensation to his shareholders? Coming, as this almost always does, from someone who has spent little time watching CEOs work, this has always seemed slightly silly: how could you possibly have any idea whether he’s worth $800 million or not?
But Harford ably outlines an even more intriguing possibility: Michael Eisner might be worth $800 million even if he does nothing at all—indeed, perhaps he’d be worth even more if he did nothing but play video games all day.
That’s because many economists believe that CEO pay is structured as it is not to spur the CEO to ever greater heights of achievement, but rather pour encourager les autres. Michael Eisner might work just as hard for $1 million a year . . . but the gigantic payoff to becoming CEO spurs those beneath him to ever-greater heights of achievement. Basically, Michael Eisner has won the employment lottery. And because the prize is so big, all of his subordinates are dutifully beavering away, vying for a chance at the gravy train.
This does a pretty good job of explaining the structure of corporation pay, but not necessarily the magnitude—one imagines that Michael Eisner’s subordinates would work pretty hard to get a shot at even a mere $400 million in total compensation. This is where the explanation that I have previously favored comes in: captive boards doling out favors to CEOs. As Mr. Harford explains, each shareholder’s contribution to even a truly outlandish CEO pricetag is too small for them to take much interest in holding it down. The games that companies were recently revealed to be playing with their stock options show just how lamentable a state shareholder supervision of boards is—and I wish someone had a better answer to the question of why large institutional investors aren’t more active in corporate governance.
The other thing tournament theory doesn’t explain very well is why CEO salaries have changed. I wish this chapter had contained more on the shift, which started in the 1980s but really got going in the 1990s, towards ever larger CEO paychecks. This is not a criticism—as every writer knows, there’s always too much good material to slide by your editor’s miserly word counts—but still, I wish. There are a lot of plausible candidates out there: changes in financial theory, the stock market boom, deregulation, dilution of shareholder interest by changes in the capital markets, even a cultural shift—and I would like Mr. Harford to help me sort through them.
Comparison of today’s American companies with the companies of the 1980s, or their current European counterparts, would seem to reveal that the tournament is an effective, if perhaps a little distasteful, structure. Americans are widely known for working harder than Europeans. Moreover, current American companies are not only far more productive than they used to be, but also enjoy significant productivity advantages over their foreign counterparts in critical but harder-to-measure areas like logistics and IT. When American companies take over companies abroad, suddenly their IT operation seems to improve dramatically. These differences may go a long way towards explaining the growth differentials between the two regions.
We want to hear what you think about this article. Submit a letter to the editor or write to email@example.com.