CEO compensation has become increasingly controversial, including cases where executives have received particularly high amounts of performance compensation, exotic or unusual features such as loans from the firm (which are now banned), post-retirement benefits, perks, and guaranteed post-employment consulting contracts. As with all employees, economic theory holds that CEO pay should never exceed the CEO’s marginal revenue product (MRP), the incremental value the CEO provides for the firm. MRP, however, is difficult to measure. Furthermore, because executives supervise others, it can be problematic to apportion marginal revenue generated by the worker being supervised from that generated by the executive doing the supervising.
CEOs provide managerial, administrative, and supervisory services, and some executives provide the firm’s entrepreneurial planning. The firm’s entrepreneurial plan is a productive resource that directs the other factors of production and earns a specific category of economic income: profits. Profits are distinguished from the wages paid to labor in economic theory, but both may be included in the compensation paid to the CEO. To the extent a CEO’s good leadership enables workers to be more productive, they may be entitled to a share of that addition to the firm’s revenue, though this argument fails when a micromanaging CEO prevents subordinates from being as productive as they would have been otherwise.
As a practical matter, firms typically group similar workers, classifying them, for example, according to their expertise, experience, function within a firm’s entrepreneurial plan, seniority, and other factors. Within the admittedly somewhat arbitrary structure imposed by these intra-firm classification systems, the total revenue product and MRP will actually differ from worker to worker, but many such differences will be ignored by the classification scheme and compensation structure. These shortcomings in what determines the firm’s labor demand and wage offers help explain why workers seek collective bargaining. Firms have an incentive to avoid motivating their labor forces to seek union representation, but this must be balanced against the firm’s profit-maximizing motivation to structure their MRP classifications and offer wages to minimize the total wages paid to labor.
To some extent the firm can lower its wage bill by miscategorizing labor so that it pays them below their actual MRP. Firms may benefit financially from categorizing workers in such a way that they underpay as many workers as possible by as great an amount as possible, but doing so necessarily reduces worker morale and willingness to deliver high productivity. Furthermore, it disadvantages the firm in competing to hire the most productive workers with the highest actual MRPs. The greater the wedge between worker MRP and their wages, the greater the incentive for workers to unionize and bargain collectively, and the greater their incentive to seek alternative employment. Executives, especially new hires and entry-level managers, face the same kind of incentives for the firm to miscategorize them, which would result in their being undervalued and underpaid. This underpayment is due to imperfections in the firm’s pay scale and classification structure, but the impact of miscategorization seems to be easier for employees to alleviate by direct negotiation the higher the employee is in the corporate hierarchy.
For newly-hired CEOs, MRP includes the additional revenue the firm achieves over and above what was realized under their predecessors, but also the unobservable difference between the firm’s actually realized financial results, and what the firm would have attained without the new executive’s contribution and leadership. Any appraisal of this quantity must be subjective, explaining why estimates and expectations generally skew optimistic — leading to high compensation offers for new CEOs. This presents special challenges to corporate directors and compensation committees, who have to recommend, justify, and approve raises for specific individuals, as well as overall compensation schemes. Some part of executives’ compensation is clearly not associated solely with expected or realized MRP, coming instead from their role as a manager of the firm’s resources. CEOs define what management science calls the locus of control for their subordinates, including middle managers and the rank-and-file, and potentially can extract or capture some of the revenue earned by other factors of production: land, labor, capital, and entrepreneurship, which they supervise.
The economic literature on wage determination recognizes that information imbalances (where the firm knows more than employees about what their peers are paid elsewhere, what wages they will accept, and how to minimize the firm’s wage expenditures) can result in employees being paid far below their MRP, especially if labor markets are less competitive. Such asymmetric information would create obvious inequities, for example, management receiving their MRP or greater, while labor receives less than theirs. This would also help explain why labor organizes and bargains collectively, and why employees need to — in order to counteract the firm’s greater market power. An argument can also be made, however, that executives should be compensated with a share of the cost savings they create for the firm, whenever they successfully reduce the firm’s production costs. One example of such a cost saving is the implementation of a compensation scheme that lowers operational expenses by undercompensating other employees. Nevertheless, executive compensation should also be tied to morale, productivity, and labor peace, as much as to tangible short-term financial results. Even though there are obvious financial incentives for the TMT to exploit the rank-and-file as egregiously as possible to minimize short-term costs for the firm, such behavior could never be presented as being either ethical or a best practice. Furthermore, it seems unlikely that such predatory conduct would serve the firm’s long-run interests.
In its impact on compensation, information asymmetry typically favors higher-level executives, or at least penalizes them less. A rank-and-file worker with a very high MRP, for example, is less likely to be aware of the relatively high wage he could receive by defecting to an alternative employer, and will generally not be as well positioned to bargain successfully for a raise approaching his high MRP. Nor is it likely to occur to him that he could earn more money by defecting to another employer. In contrast, higher-ranking executives face smaller markets and are especially well-informed about what their peers make. Because there are fewer CEOs than rank-and-file workers, and CEO compensation is often widely publicized, the burden of collecting CEO compensation information is lower, and the potential reward greater.
Since CEOs manage the allocation and deployment of all the firm’s factors of production or resources, this gives them a unique opportunity to capture some of the income generated by the firm’s other resources. CEOs are also uniquely able to absorb the profits of any entrepreneurial planning performed by their subordinates. A CEO may retain these captured profits exclusively for himself, share part with middle management, allow part to be distributed among shareholders or labor, or any combination of the three.
Among other things, the CEO is responsible for determining the compensation of all other employees and has an incentive to estimate employee MRP as accurately as possible. When it comes to their own compensation, however, CEOs face a conflict of interest, in that they also desire to maximize their own compensation, and directors who approve executive compensation are often a particularly sympathetic audience
Executive compensation committees need to examine CEO compensation closely and critically in light of explicit and measurable strategic objectives the board articulates for the firm. The CEO’s contribution to firm profits may be substantial, and this may justify most of their compensation, however large.
Behavioral economics contributes the insight that different kinds of compensation incentivize, reward, and support different kinds of behavior, so a range of justifications for executive compensation may come into play and need to be considered by directors and the compensation committee. Any kind of incentive compensation in addition to regular salaries, such as bonuses, sales commissions, performance pay, stock options, and the like should be designed to ensure it properly incentivizes the behavior or performance the board wishes to see realized, ideally in accordance with preannounced, transparent, and objectively measurable strategic outcomes. One of the most important components of strategic planning is incentivizing the kind of performance the firm seeks to achieve.
