Sunday, September 23, 2018

Does economics explain high CEO salaries? Yes

Are CEOs Paid Too Much? - Foundation for Economic Education - Robert P. Murphy:

October 1, 2006 - "So what if CEOs earn more money than most other workers? In a free market (and below we deal with the complication that in today’s world there is no truly free market), the price of labor corresponds to its marginal product. That is, competition ensures that workers are paid according to how much additional revenue they bring in to their employer. The fact that some types of labor command thousands of times more market value is no more surprising or outrageous than the fact that some goods in the marketplace (such as a house) have a price hundreds of thousands of times higher than the prices of other goods (such as a pack of gum).

"But what of ... corporate leaders actually failing their way to riches?... When a company brings in a new executive ... to turn the company around ... it is entirely possible that the plan will fail — and the executive knows this as well as anyone else.... [T]he assembly-line worker doesn’t want his contract contingent on the overall profitability of the company; he wants to be paid — and to get his pension and other benefits should he retire or quit — whether or not the company’s stock does well. If it’s acceptable for the assembly-line workers, why not for the CEO too?

"Yet ... CEOs and other executives do get paid according to how well the company does. In addition to a base salary, these executives are often paid in stock options [i.e.] the right to purchase shares of stock at a specific price, called the strike price.... [I]f the actual market price of the stock [falls] lower than the strike price, the option is worthless ... options are valuable [only] in proportion to the difference between the strike and actual prices.

"We must accept that in the modern economy, with billions of potential consumers worldwide, certain individuals have extraordinary earning power on the open market.... These people aren’t qualified for just CEO spots, and they’re well aware of the social stigma against big business. If the compensation packages are as high as they are, it’s because that’s what firms need to offer to attract and retain these highly skilled individuals....

"If ... management collectively frittered away $10 million per year in unjustifiable expenses, the total shares of the corporation would be valued around $200 million less than they otherwise would be, assuming an efficient stock market and an interest rate of 5 percent.... Such a corporation would then be a prime target for the much reviled corporate raider. The raider would institute a 'hostile takeover,' in which he bought up a controlling share in the corporation (by offering far more than the current price per share to the stockholders) and then used his power to fire or straighten out the inefficient managers. After cleaning house the corporation’s dividends and/or stock price would rise accordingly, netting the raider a profit.

"Unfortunately ... the above relies on the assumption of a free market in corporate takeovers, and that is decidedly lacking. In the present legal and cultural environment, so-called corporate raiders are even more despised than golden-parachuting CEOs. Regulations severely restrict so-called hostile takeovers, and hence hamper the ability of shareholders to restrain their managers....

"The market’s other checks on inefficient management are stifled as well. After all, ... there was always a sure-fire way to keep corporate officers in line: any firm that wasted too much money on fancy offices and executive perks would be vulnerable to its competitors.... But as with hostile takeovers, so too with new entrants to industry: Government regulation muffles this threat and thus allows entrenched businesses a margin of profligacy that they otherwise would not enjoy.

"Many people (especially young students) new to the ideas of laissez faire believe that big business opposes government meddling, but this is naïve and contradicted by the history of actual legislation. Ironically, the profitability of big business can actually be enhanced when the government regulates an industry, because the big firms can more easily handle the fixed costs of filling out paperwork ... and so on.... In this environment, would-be competitors face additional hurdles if they want to challenge the large incumbents, and thus the latter may indeed get away with lavish expenditures that would be short-lived in a truly free market."

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See also: Does economics explain high CEO salaries? No

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