Corporate Governance

1. Corporate Governance Handout 8 Compensation issues

2. Are CEOs paid `too much’? One of the most publicized issues regarding corporate governance is the amount of CEO compensation. Many people think that CEO compensation is outrageously large, and that CEOs are overpaid. We have already asked the question ‘Are CEOs paid effectively’, but we did not ask this question ‘Are CEOs overpaid’. Although it is difficult to answer to this question, it is worth a discussion because this is one of the most commonly asked questions.

3. Before asking the question ‘Are CEOs overpaid’, a good question to ask would be ‘why is the amount of CEO compensation so high?’. Question Why should the amount of CEO compensation be so high?

4. Why should the amount of CEO compensation be high? There should be many reasons why CEO compensation should be high. Some of the reasons would be CEOs have higher responsibilities High CEO compensation would provide good incentive for junior workers who aspire to be the future CEO. We discuss above reasoning one by one.

5. Responsibility and compensation One reason why a CEO is paid a large amount of compensation is that, the CEO has greater responsibilities. To be more precise, the CEO has a greater responsibility in a sense that the CEO’s decision affects all the workers who work under him/her, directly or indirectly. In other words, the CEO has a great span of control.

6. Organization

7. You can imagine the situation where an improvement in a decision of upper rank improves the productivity of workers at the next lowest level in a multiplicative way. Thus, an improved productivity of a worker in a higher rank will have a multiplicative effect at every node under the rank, and will create a large spillover effect through the chain of command.

8. In this situation, it makes sense to assign the ablest worker to the position of CEO, because just a slight improvement in the productivity of CEO would greatly enhance the productivity of the whole company through the spillover effect. The CEO will be rewarded with a large amount of compensation due to his/her high ability, and because his/her high ability greatly increases the productivity of the whole company due to the spillover effect.

9. Therefore, if we base our argument on this type of reasoning, we can say that a CEO is overpaid only if the CEO is paid more than the amount justified by his/her higher ability and by the spillover effect. Unfortunately, there has been no empirical evidence that shows whether CEOs are paid more than the amount justified by this responsibility argument. There is a piece of evidence that is consistent with the responsibility argument, which is presented in the coming slides.

10. Responsibility and compensation The responsibility argument implies that (1) compensation increases with rank, and (2) that compensation increases with the ‘span of control’ or the number of workers who are working under him. Smeets and Warzynski (2008) used a personnel data from a large IT company in Europe. This company has 5 hierarchy shown in the next slide

12. The estimation model The authors used data up to middle managers only. The estimation model is Log(salary)=ß0+ß2(tenure)+ß3(tenure)2 +ß4(Age)+ß5(age)2+ +ß6(education dummy variables) +ß7(rank dummies) +ß8(Control span for managers) +ß9(Control span for mid managers)

16. Thus, the salary is increasing with the rank, and that the span of control is also associated with higher salary. These results are consistent with the responsibility argument. However, these results do not tell us whether or not the middle managers are paid more than the amount justified by their ability and responsibility. So, we are not able to answer the main question, ‘Are CEOs paid overpaid?’ Moreover, these results could be consistent with other linse of arguments as well.

17. Compensation as incentive mechanism The responsibility argument can explain why salary should rise with promotion: It increases because the responsibility is likely to increase with promotion. However, we can also find a situation where this is not the case. For example, in law firms, promotion often occurs without changing the job contents. Nevertheless, a promotion brings large increase in salary. In academia, promotion from associate to full professor do not significantly alter responsibility, but it brings substantial salary increase. These indicate that there are other reasons why salary jumps at each promotion.

18. Another way to understand why promotion brings higher compensation is that, by providing a large salary increase at promotion, firms can provide incentive for workers to work hard. In other words, this type of compensation works like a tournament.

19. A tournament like compensation This situation can be described using a metaphor of a tennis match. Consider a tennis match between Agassi and Sampras. Prizes are fixed in advance and are independent of the absolute performance: the prize do not depend on the amount by which one beats the other. The effort each player puts forth would depends on the potential gain in winning. See next page.

20. Consider that the prize money totals $500,000. The prize could be split evenly so that the winner gets $250,000 and the loser gets $250,000. Although nothing is gained financially, players might still put forth a reasonable amount of effort because people likes to win simply for pride, if nothing else. But if the prize is split so that winner gets larger amount of the prize (like $400,000 for the winner and $100,000 for the other), then the winner gets pride and also gets $400,000 richer. This suggests that the larger the spread between winning and losing, the higher the effort exerted by both player.

21. Such a situation applies to a corporation. If the company needs to induce effort, the financial compensation for winning a higher position should be high. The difference between the salary of a lower position and the salary of the higher position should be large enough to induce a good amount of effort. This situation can be described analytically as well.

22. Suppose that there are two workers, Joe and Katy. For simplicity, assume that they are identical in their productivity. They work for a company and each produces an output given by Qj1=µj+ej Qk=µk+ek Where µj and µk are the effort levels of Joe and Katy. The terms ej and ek are some random error term (we can assume that they are normal)

23. The company let these two workers compete with each other, and offer higher wage WH for the winner and a lower wage WL for the looser. Joe will win if Qj>Qk, and Katy will win otherwise. The probability that Joe wins is given by P(µj, µk)= Prob(Qj>Qk)=Prob(µj+ej>µk+ek) =P(µj-µk>ek-ej)

24. Now, think about how Joe would react to this situation. Since he will get higher wage if he wins, he would like to work hard. However, there is a cost to working hard (i.e, make him tired). Let C(µj) be the cost of exerting effort. We assume that this cost is increasing with effort, like C(µj) µj

25. Then, he would choose the effort level that maximizes the following. Maximize WHP(µj,µk)+WL[1-P(µj,µk)]-C(µj) With respect to µj. By taking the partial derivative with respect to µj, we have Where g(µj, µk) is the density function.

26. Katy’s reaction to the situation is described in the same way. Note that the probability for winning the tournament is determined by your own effort, and the effort of the other worker. If you work harder, the other one will match your effort. Thus, in the equilibrium, both provides the same amount of effort, that is µj =µk at the equilibrium

27. Therefore, the amount of effort exerted by each worker is determined by (WH-WL)g(0)=C’(µ) C’(µ) (WH-WL)g(0) µ

28. The exact spread (WH-WL) is set by the firm so as to make sure that these workers participate in the tournament (details omitted)

29. We can learn a couple of things from this reasoning. First, the greater the spread (WH-WL), greater the effort exerted by the workers. The spread does not depend on the ‘margin of winning’. One gets the winner’s prize even if one just won the tournament with very small margin. This indicates that, winner gets more than his/her contribution to the firm, and loose gets smaller than his/her contribution to the firm.

30. Now, if we see compensation scheme as a tournament, we can understand why CEO’s compensation is very high. CEO’s compensation is high not because his contribution to the firm is as large as his compensation, but because this large prize gives incentive for anybody under him/her to work hard. So, CEOs may be paid more than their contribution to their firms, but this does not necessarily mean that they are ‘overpaid’, because the incentive mechanism justifies the large compensation. So, if we use tournament reasoning, we can conclude that CEOs are overpaid only if CEOs are paid more than the amount justified by the incentive effect.

31. There has been many studies that show that a large prize for winning a tournament increases effort level. However, there has been no study that shows if somebody is paid more than the amount justified by the tournament theory. Next week’s handout will introduce one study that uses a clever method to indicate that some CEOs may be ‘overpaid’.

32. References Lazear, Edward, and Sherwin Rosen (1981). ‘Rank-order tournaments as optimum labor contracts’. The Journal of Political Economy, Vol. 89, No. 5 (Oct., 1981), pp. 841-864 Rosen, Sherwin (1982) ‘Authority, Control, and the Distribution of Earnings.’ The Bell Journal of Economics, Vol 13, NO.2 Autumn, pp. 311-323 Smeets and Warzynski (2008). ‘Too many theories, too few facts? What the data tell us about the link between span of control, compensation and career dynamics’. Labour Economics 15, pp. 688-704.