Marginal Revolution
If you read carefully my post from yesterday, you may have noticed what a tricky question this is. “CEO” of course is a discrete position, and while there are companies with “zero” or “two” CEOs, those comparisons are not the correct ones to define marginal product; in any case they would give you two very different numbers.
Nor is it correct to compare “this CEO” to “his likely replacement.” That difference could be zero, but it does not mean the CEO adds zero value or will or should receive zero pay. Keep in mind that we are already juggling a few margins here, including “getting this CEO to work harder or better” and “this CEO vs. another.”
Alternatively, imagine there are ten firms in the economy, of differing size and import, all bidding for managers in a pool of fifty people. A credible CEO offer has to satisfy a participation constraint, namely getting the candidate to take the job over CEO at a lesser firm or working in a lesser job. But if a CEO can add 50 percent of value to a firm, that CEO will not in general be paid fifty percent of the firm’s value and need not be paid anything close to that. The shareholders know he will take the job for less and there are other candidates who might add forty-seven percent of value. The firm can make a credible offer of “two percent of value added” and it might be accepted.
Unlike hiring widget-makers for “less than their marginal product,” there is no subsequent disruption of equilibrium which must follow from this apparent disjunction of CEO pay and marginal product. For instance there is no firm-level incentive to further expand output or hire extra CEOs. There is one discrete slot, a wide range of potential compensation values, and the final sum is set by a bargain, determined by the context of principal-agent theory.
CEOS who can add so much value will try to start and grow their own firms, holding lots of equity from the very beginning, as Mark Zuckerberg has done. Those CEOs will indeed be paid something like their traditional marginal product, but they are a distinct minority and wealth and risk constraints limit their number.
In general, it is confusing to suggest that CEOs will be paid their marginal product. The traditional notion of marginal product does not apply to a CEO in the simple “widgets per worker” way. There are ways you can define “marginal product” to make the claim “CEOs are paid their marginal product” more or less true, but that is not my preferred way forward. Instead we should get more used to thinking intuitively within the principal-agent model, even though it is harder to do.
20 comments
Bang Dang Nguyen and Kasper Meisner Nielsen have studied the question of CEO value by looking at market reactions to sudden CEO death: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1695366
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One of the striking things about Steve Jobs – which wasn’t dealt with in any obituary/retrospective that I read – was how little money he made relative to the market cap growth he generated in his second tenure with Apple. I’m still amazed he was worth a paltry 10 figures. Apple shareholders got a great bargain.
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Lleonard Mlodinow writes about something similar in his book “The Drunkard’s Walk”. His analysis isn’t as generous as Tyler’s, however.
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I wonder about the methodology. A lot of what makes a good CEO is his ability to assemble a good team underneath him. (This holds for even a superstar like Steve Jobs.) These other executives contribute to the corporation’s value. It seems strange to claim that the CEO is worth all the extra value added; surely some of that belongs to his underlings. i.e. Your analysis implies that Tim Cook isn’t worth a penny; that all the value he added to Apple should be marked in Steve Jobs column for hiring and promoting him.
I also wonder about the slotting aspect. Perhaps it makes more sense to improve the sum quality of the top 10 executives at a company rather than pay extra for the number 1 executive.
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You make a great point. For this type of analysis to make sense there would need to be a law of exclusivity for marginal product. When you have complicated violations of independence such as hiring and firings of producers as the major contributions of other producers, things get messy quickly.
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I think this is a necessary simplification given the current level of understanding. If it makes you feel better you can replace “Steve Jobs” with “Team Jobs.” Once the current CEO questions are sufficiently answered we can add details later.
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I like the idea that our intuition should be driven by theory – I often wish Tyler makes this point more explicit in his other posts. For this particular post, I would argue that the usual principal agent model is likely to fail, because there is no competition between principals. Perhaps it is better to move the debate towards a discussion of equilibrium matching theory. Again, no easy answers for anyone not trained or not willing to think using an equilibrium analysis – but why should there be.
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I take your point about “likely replacements” but I think that you are missing the zeitgeist behind anger over executive pay.
I doubt many would argue passionately against paying CEOs $200k per year. They do a job not everyone could do, and they are at the top of the economic food chain. However, when you have CEOs making millions of dollars per year, the justification becomes much more difficult in peoples minds. That space between $200k and $2mil provides a nice space upon which to find your margins. That margin space may not fall all the way down to $0, but one could easily ask if a replacement within that class of CEO provides any measurable value to the company.
That is where economic analysis could help in answering questions about policies such as relative-wage caps, and enlighten the public debate.
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I can’t believe you have another post on this without acknowledging that your interpretation of the paper you linked to yesterday was completely wrong. The CEO’s marginal product is not 100% of all changes to shareholder value that occur during his tenure!
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It must be fund raising time at Mercatus and Tyler is looking to get on the good side of Santa Claus.
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“But if a CEO can add 50 percent of value to a firm, that CEO will not in general be paid fifty percent of the firm's value and need not be paid anything close to that. The shareholders know he will take the job for less and there are other candidates who might add forty-seven percent of value. ”
But, in this case, this not mean that the marginal product of that CEO is 3%?
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The paper that Guan Yang cites above estimates that CEO’s capture 80% of their value added.
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Tyler, you never responded to those commenters in your previous posting that the study you cited in no way computed marginal product correctly. The increase (or decrease) in value of the company is NOT the marginal product of its CEO. It is arguable that the CEO was the biggest factor in any change in value, but I don’t believe any CEO creates 100% of the change. And usually a whole lot less than 100%.
Also, I believe you are incorrect when you claim that replacement cost is not a fair description of value. Perhaps that doesn’t give the marginal product of the CEO, but determining that is so far impossible. In any case, the compensation received by a CEO should not be equal to his marginal product, any more than any other worker. The firm would never make money if it paid its workers the amount of their marginal product. What every worker gets paid in a rational free market economy depends on the supply and demand of those workers. This makes sense for CEOs as much as for widget makers, whether or not there is one CEO per firm or one widget maker per company. Thus, it is the cost of potential replacements for the CEO that should determine his value. If a replacement CEO would bring the same value to the firm but charge less than the current CEO, then the current one is overpaid.
Of course the problem is determining the value each CEO brings to the table. A good CEO is worth a lot more than a bad one, and the difference is likely much more than even the over-inflated salaries that CEOs now receive. And that is no doubt the reason for these enormously high salaries. Every Board of Directors thinks it knows which are the good CEOs and which are the bad ones, and of course they hired the best. The problem is, most of these BODs are wrong. I suspect that most potential CEOs (including those that never become CEOs, that are one or two levels down), have approximately the same value as the ones running things. If I am correct, then the high salaries are much higher than they need to be. It is only if potential replacements for the current CEOs are much worse than the incumbents, that the current salaries make sense.
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The problem with all the analysis is the high level of abstraction. Tyler ought to take a firm or two and compute the Marginal Products of their CEO’s. One needs hard numbers to see if any of this makes sense.
I am afraid we are trying to build a vague metric which cannot be usefully computed.
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“Of course the problem is determining the value each CEO brings to the table. A good CEO is worth a lot more than a bad one, and the difference is likely much more than even the over-inflated salaries that CEOs now receive. And that is no doubt the reason for these enormously high salaries. Every Board of Directors thinks it knows which are the good CEOs and which are the bad ones, and of course they hired the best. The problem is, most of these BODs are wrong…”
That’s the first sensible comment I’ve seen on this issue – though you might also point out that the value of a ‘bad’ CEO is likely to be a large negative number. Thus far Tyler has (unusually) produced little that makes any kind of sense.
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Another thing to consider is that CEOs are getting paid in other ways than just money: power, status, etc. It’s one of the reasons NBA players will accept less money to play on a “champion” team, etc.
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This is just silly. If one CEO is judged comparable to a likely replacement, that doesn’t mean his or her marginal product is zero or that he or she should be paid zero. Who ever said that?
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