Posts Tagged ‘ CEO pay ’

Executive Compensation Part II: Spoiling the Good Child

Aside from the objectively huge¬†effect that executive decisions can have on a firm’s bottom line, there is at least one more compelling reason to pay top executives more than their own marginal product (in a sense). A professor once suggested to me that a CEO’s full marginal product includes not only the value of his policy, branding, and motivational actions, but also his motivational inactions. Basically, by over-compensating a CEO in terms of what he actually does, a firm presents a big carrot to anyone within shouting distance of the position. Of course, this practice shouldn’t begin or end with a company’s top man; indeed there are gains to be had from over-compensating employees at every level, even the ground level (consider a firms desire to attract the best entry-level applicants).

Obviously, this practice will always scale with the classical value of the positions in question; how big is the spread between the median dishwasher and one who performs in the 95th percentile? It will also compound towards the top, each supervisor is paid to increase the output of those beneath her, both explicitly and implicitly; the more supervisors and the more tiers beneath you, the great the ripple effect of your desirable salary.

I don’t think this theory is far-fetched in the least. As I’m not so well versed on the subject, it may even be common knowledge in relevant circles. What I do find very interesting are this strategy’s applications outside of the hierarchical firm.

All of this came very keenly to mind when talking to my 24 year-old friend who still lives quite amicably off the trough of her parents. The interesting thing is, her 21- year old brother is being cut off. My friend’s justification for her disproportionate compensation? She stays out of trouble, got through college in a reasonable amount of time, and does errands upon request. Her brother is hardly a degenerate; he does poorly in school, but still attends regularly, he stays away from hard drugs, doesn’t run in criminal or otherwise dangerous circles and is usually home at a decent hour. He is more impulsive, serially lazy, and temperamental, but you can squeeze a favor out of him now and then.

Basically, children are always better compensated, often into their twenties than the services they provide to their parents would ever warrant. But why the disparity in the case of my friend? She does provide more than her brother, but not nearly to the degree (and length of time) that she’s been better taken care of. My leading hypothesis is that my friend is enjoying the spoils of implicit motivational compensation. Just by being a relatively good child next to a less well behaved sibling, she enjoys the fruits of being a vegetable (carrot), that she likely wouldn’t if her wayward brother wasn’t around to, perhaps, learn his lesson.

Executive Compensation Part I: Resolving Market Failures

When it comes to executive compensation, most people like to make it a distributive issue; the asymmetry of the typical large firm is just very off-putting for many. And the feeling comes from the tendency in most arguers to identify with the mass of workers near the bottom of the hierarchical firm, regardless of where their place may actually be. Some others go as far as saying that excessive compensation of CEOs is actually bad for the firm insofar as it increases turnover and decreases the quality of work at the bottom and over all demand for product (this last claim is common, but ridiculous). Overall, I’m not here to make a comment on what I believe optimal executive-worker compensation ratios are, or how distant those are from what we observe. I’m here to point out some interesting ways in which top executives, who seem so detached from a business’s direct sources of revenue, justify their enormous salaries. My general theory is that their skills and attributes as employees serve only to get them into top positions, but it’s the positions themselves, which are so valuable to good corporate governance, that demand high valuation.

Top executives are trusted to make sweeping policy decisions that can easily move markets and earnings in huge ways and, often enough, make or break entire companies. It’s my belief that the fact that most CEOs tend not to make horrible gaffs speaks less to the ease of the decisions (made with great advisory teams on hand) and more to the ability of boards to select great decision-makers. ¬†One thing I’d like to consider is the kind of policy an executive hands down to alter employee behavior in such a way as to neutralize intrafirm market failures: instances in which rational behavior for individual employees collectively destroys earnings.

Take a simple example. At one point, “employees must wash hands” wasn’t even posted in the toilets at fast food restaurants and this was of course long before the days of disposable food prep gloves. No employee would go through the trouble of bringing in their own sanitary gloves when it wasn’t expected and some portion might not have even bothered washing their hands. One bold, though retrospectively easy, decision from a top executive immediately reduced instances of food poisoning and the associated legal/reputational liability and instilled a sense of cleanliness and security that dramatically increased brand value. After years and years as the law of the land, you can imagine the millions that such a marginal decision could tally up. All of that increased income is down to a single employee who, in making across the board cost-saving and revenue increasing decisions for his front-line workers, has increased their productivity in ways they would have never bothered to with very rare exception.