Research and Theory Indicate CEO Incentives Are Close to Optimal

Chief Executive (U.S.), March 2005 | Go to article overview

Research and Theory Indicate CEO Incentives Are Close to Optimal


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. …

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Research and Theory Indicate CEO Incentives Are Close to Optimal
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