Research and theory indicate CEO incentives are close to optimal

Chief Executive, The, April, 2005

Economics 101 teaches us that wages in a competitive market should equal the marginal product of labor. That means with perfect competition we should pay people for what they produce: no more no less. As the hunting season for overpaid CEOs begins, any true economist must ask the first question in any analysis of executive compensation: how much productivity did the CEO create?

To be fair, we must acknowledge that markets don't always get this fundamental law right and that markets aren't perfectly competitive. Sometimes they overpay CEOs and sometimes they underpay them. While most of the media is concerned with tracking down those CEOs who received more than their fair share, very little attention is paid to whether the markets get it right, and if they don't, what can be done about it.

There are arguments on both sides of the fence. The AFL-CIO, New York Times, and many other media outlets tend to assume that CEO pay is out of control and needs to be arrested. They advocate their points by parading highly paid CEOs in front of the media and comparing CEO compensation to that of the minimum wage workers (implicitly assuming that minimum wage workers have the same productivity levels as Chief Executives).

Nevertheless, shareholders, corporations, and the free market continue to offer massive pay packages to individuals--these groups, when they come under pressure tend to shame themselves when they are attacked by the media for their large payouts. Said George David CEO of United Technologies when asked for a comment about his $70.5 million pay package from 2003, "I'm a little embarrassed about it."

As the CEO Index begins its look into executive compensation, our intent is to change the landscape of current discussion and refocus it on far more important questions about executive compensation and productivity. It is our hope to have readers be skeptical of headlines that compare CEO pay to minimum wage workers, but at the same time ask whether CEOs were compensated to the extent of the shareholder value they created.

Our question this month asked CEOs what percentage of their pay was tied solely to performance--the average reported amount was 42.8%. Executives at public companies reported lower levels of performance based pay (37.2%) vs private company executives (43.4%). While at the surface this may seem a disturbing trend, the demand for high performing CEOs at public companies is significantly higher than for private companies and therefore would lead to higher wage rates. Furthermore, research suggests that CEO incentives at larger corporations must be relatively higher than those at smaller companies because of their typically lower equity holdings. Executive compensation is a complex topic, boiling it down to a headline is a process typically fraught with bias or oversimplification.

CEO pay should be based on performance. Actually calculating the shareholder value added by a CEO in a specific company during a certain economic cycle can be an elusive task. A market theory of executive performance measurement would suggest that given the amount of data available, processing power, our understanding of human behavior and the firm, and technology, the market will only get better at valuing CEOs and paying them accordingly as time progresses. Many researchers argue that firms are doing a pretty good job, Haubrich and Popova, academic researchers in the field of executive compensation wrote in their journal article in Economic Theory, "The results [of our analysis of CEO compensation] suggest ... that actual incentives are close to the optimal incentives predicted by theory."

Still we read articles of CEO pay and are outraged or jealous. The empirical question of whether or not we are sufficiently good at evaluating CEO performance can remain unanswered--what should not be questioned is that the desire of the markets and the increased education of the citizenry will only lead to improvements in paying executives.

RELATED ARTICLE: Executive Compensation by the Numbers

25.2 2003 compensation for Alex Rodriguez, highest paid baseball player, in millions of dollars.

-28.5 Operating income of the Texas Rangers in 2003, in millions of dollars.

20 Pay per film for Julia Roberts, highest paid actress in 2004, in millions of dollars.

86.6 U.S. Box Office totals for Ocean's Twelve (Julia Roberts' 2nd film of 2004), in millions of dollars.

148 2004 compensation for Rueben Mark CEO of Colgate-Palmolive, highest paid CEO in 2004, in millions of dollars.

660 Increased market capitalization of Colgate-Palmolive in 2004, in millions of dollars.