Sunday, February 15, 2015

Why are CEOs paid so much?

Many people today complain about the pay of CEOs. Today's CEOs make 200 - 300 times as much as the average worker, up from 20 or 30 times in the 1970's. Many on the left want the government to reel CEO pay in, either through direct regulation or indirect regulation like a binding say on pay.

But why do CEOs make so much? A model can help us sort through this question. Below is a model showing wage on the vertical axis and effort on the horizontal axis.

There are 4 wage levels depicted, W1 through W4. There are also two marginal cost curves, MC1 and MC2. Now suppose you are on the board of directors and you want to make sure that the CEO you hire gives their maximum effort, E*. If their marginal cost of effort is like that of MC1, you could pay them a wage of W3. A marginal cost curve that looks like MC1 means that the cost of an additional unit of effort is increasing at a constant rate. That is, every new unit of effort costs more than the last but the cost goes up by the same amount each time. In a world where MC1 depicts reality the CEO who enjoys spending time with their family will incur a higher cost each hour they work but the rate of increase is constant. So the 40th hour of work might be worth $50, the 41st hour worth $55, the 42nd hour worth $60, etc. with each hour costing an additional $5. In this world a wage of W3 would induce the CEO to give their maximum effort, E*.

But what if the cost of effort is not like MC1, but instead it is like MC2? A marginal cost of effort like MC2 means that each additional hour is not only more costly, but the cost is increasing at an increasing rate. So the 40th hour is worth $50, the 41st hour is worth $57, the 42nd hour is worth $65, etc. Reality is more like MC2 than MC1. The more you work, the more you would rather be doing something else because each additional hour of work is forcing you to give up things that are more and more important to you. Missing family breakfast is costly but many working people, including CEOs, choose to bear this cost. Missing Timmy's baseball game and Mary's recital are costly, but again many working people have made this choice. But what if you had to work 80 hrs per week and miss every baseball game and every recital, in addition to missing breakfast and most dinners? Working hours 60 - 70 are more costly than hours 50 - 60. And hours 70 - 80 are probably a lot more costly than hours 60 - 70 because so much has to be given up in the form of lost time with family, hobbies, and even sleep. I think it is very reasonable to assume that the cost of working the 72nd hour is not only more than the 42nd hour, but a lot more. A marginal cost of effort that increases at an increasing rate is consistent with MC2.

If MC2 is the appropriate cost then it takes a big jump in the wage to induce the CEO to give effort E*. At W3 the CEO will only give effort E1, whereas with MC1 W3 led to E*. With MC2 the CEO will need to be paid W4 to give effort E*.

CEOs often work very long hours. They spend a lot of time traveling and being away from their families. They rarely take vacations. They are under intense pressure from shareholders, government regulators, and their customers to make the perfect decision. One wrong move can result in a hefty fine from some government agency, a decline in the stock price that wipes out billions of dollars in shareholder value, or a bad product that alienates their customers. In a world of 24/7 news and instant financial analysis, CEOs are under the microscope way more than CEOs in the 1970s. Not only that, but competition is international in scope. In 2015 companies from around the world compete with each other. International competition and trade were smaller in the 1970s. CEOs didn't have operations in every time zone that had to be monitored nor did they have 20 sets of government regulations that they had to abide by. CEOs of major companies today are the leaders of global entities and it takes a lot of time and effort to run something so large.

Most CEOs spend time as some other senior level executive before becoming a CEO. Those positions require a lot of time and effort too, but much less than being the face of the company. Anyone who follows the news knows that Jamie Dimon is the CEO of JP Morgan Chase, but who is the COO? Or Treasurer? or SVP of government relations? It takes a relatively big bump in pay to induce someone to move up to the top level from an already high paying position that is much less stressful and time consuming. The increase in stress and time costs are so great that the best people wouldn't do it for a 10% bump in pay.

And if the board thinks that the best CEO can increase the value of the company by $2 billion dollars over 10 years while the second best would only increase it by $1.5 billion it makes sense to pay another $10 million a year to get the best person for the job. That's a cost of $100 million for an increase in value of $500 million. A small % change in the value of a large company means big dollars for investors. CEOs that can increase value by 3%/year are way more valuable than those that can increase it by 2%/year. That marginal change in % means a big change in actual dollars.

So the next time you hear about CEO pay being out of control think about what it takes to be a CEO. There are certainly examples of bad CEOs that turn out to not be worth $10/hour, but there are many more CEOs that make a lot of money for their investors and are responsible for making great products available to consumers. For every bad CEO that harms a company there are 10 more who are helping their investors, employees, and customers achieve great things. Unfortunately those CEOs are the ones we never hear about.

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