Digitized by the Internet Archive in 2011 with funding from Boston Library Consortium IVIember Libraries http://www.archive.org/details/whyhasceopayincrOOgaba 3 HB31 OEWEY .M415 1^0c'^ Massachusetts Instittite ofTechnology Department of Economics Working Paper Series WHY HAS CEO PAY INCREASED SO MUCH? Xavier Gabaix Augustin Landier Working Paper 06-1 January 26, 2006 Revised: May 8, 2006 Room E52-251 50 Memorial Drive MA Cambridge, 021 42 This paper can be downloaded without charge from the Social Science Research Network Paper Collection at http://ssrn.com/abstract=901826 MASSACHUSETTS INSTITUTE OFTECHNOLOGY JUN 2 2008 LIBRARIES Why Has CEO Pay Increased So Much? Xavier Gabaix Augustin Landier MIT and NBER NYU May 8, 2006. First version: January 26, 2006* Abstract This paper develops a simple competitive model of CEO pay. A large part of the rise in CEO compensation in the US economy is explained without assuming managerial entrenchment, mishandling of options, or theft. CEOs have observable managerial talent and are matched to assets in a competitive assignment model. Under very general assumptions, using results from extreme value theory, the model determines the level of CEO pay across firms and over time, and the pay-sensitivity relations. The model predicts a cross-sectional constant-elasticity relation between pay and firm size. It also predicts that the level of CEO compensation should increase one for one with the average market capitalization of large firms in the economy. Therefore, the six-fold increase ofCEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization oflarge US companies. The model can also be used to study other large changes at the top of the income distribution, and offers a benchmark for calibratable corporate finance. We find aminuscule dispersion of CEO talent, which nonethelessjustifies large pay levels and differences. The empirical evidence is broadly supportive of our model. The size of large firms explains many of the patterns in CEO pay, in the time series, across industries and across countries. (JEL D2, D3, G34, J3) Keywords: Executive compensation, wage distribution, pay performancesensitivity, extremevalue theory, superstars, calibratable corporate finance. *[email protected], [email protected]. We thankHae Jin Chung, Sean Klein and Chen Zhao for excel- lent research assistance. For helpful comments, we thank Daron Acemoglu, Olivier Blanchard, Alex Edmans, Bengt Holmstrom, Hongyi Li, Kevin J. Murphy, Andrei Shleifer, David Yermack and seminar participants at Chicago, MIT and the University of Southern California. We thank Carola Frydman and Kevin J. Murphy for their data. 1 Introduction This paper proposes a neoclassical model of equilibrium CEO compensation. It is simple, tractable and calibratable. CEOs have observable managerial talent and are matched to firms competitively. The marginal impact of a CEO's talent is assumed to increase with the value of the assets under his control. The model generates testable predictions about CEO pay across firms, across countries, and across time. In particular, it also explains, quantitatively, much of the rise in CEO compensation since the 1980s. In the model's view, this increase in pay is due to the rise in the market value of firms. Our talent market is neoclassical and frictionless. The best CEOs go to the bigger firms, which maximizes their impact. In the benchmark case, incentive considerations do not matter. The pa- per extends earlier work (e.g., Lucas 1978, Rosen 1981, 1982, 1992, Tervio 2003), by drawing from extreme value theory to obtain general functional forms for the spacings in the distribution of tal- ents. This allows to solve for the variables of interest in closed form without loss of generality, and generate concrete predictions. In equilibrium, under very general conditions, we establish that the compensation of a CEO in firm i is: CEO compensation (n) = D (n.) • 5(n.)^-'' S (n)" (1) where k and D [n^) are positive constants, S {n) is the size of firm i, and 5(7i*) is the size of a reference firm - for instance, the median market capitalization amongst the largest 500 firms. Hence, ~ the model generates the well-established relationship between compensation and size (with k, 1/3 empirically). The model also predicts that average compensation should move one for one with typical market capitalization S{nt,) offirms.^ Figure 1 offers evidence for this effect. Historically, in the U.S. at least, the rise ofCEO compensation coincided with an increase in market capitalization ofthe largest firms. Between 1980 and 2000, the average asset value of the largest 500 firms has increased by a factor of 6 (i.e. a 500% increase). The model predicts that CEO pay should increase by a factor of 6. The result is driven by the scarcity of CEOs, competitive forces, and the six-fold increase in stock market valuations. Incentive concerns or managerial entrenchment play strictly no role in this model ofCEO compensation. In our view, the rise in CEO compensation is a simple mirror of the rise in the value of large US companies since the 1980s. Our model also predicts that countries experiencing a lower rise in firm value than the US should also have experienced lower executive compensation growth, which is consistent with European evidence (e.g. Conyon and Murphy 2000). We show that a large fraction in cross-country differences in the level of CEO compensation is explained by differences in firm size. We also show that within the US, the distribution offirm size within industries determines the level of compensation as our model predicts: both firm size, S, and the benchmark firm size, S (tt.*) , are significant predictors of CEO compensation. Finally, we offer a calibration of the model, which could be useful to guide future quantitative models of corporate finance. The main surprise is that the dispersion of CEO talent distribution appeared to be extremely small at the top. If we rank CEOs by talent, and, at the head of a firm, replace CEO number 1 by CEO number 1000, the value of that firm will decrease by only 0.04%. However, these very small talent differences translate into considerable compensation differentials, as they are magnified by the size of very large firms. 'Plugging S — S{n,) in Eq. 1, the compensation in the reference firm is D(n.)S(n,). The rise in executive compensation has triggered a large amount of pubUc controversy and acad- emic research. Our theory is to be compared with the three main types of economic arguments that have been proposed to explain this phenomenon. The first explanation attributes the increase in CEO compensation to the widespread adoption ofcompensation packages with high-powered incentives since the late 1980s. Holmstrom and Kaplan (2001, 2003) link the rise of compensation value to the rise in stock-based compensation following the "LBO revolution" of the 1980s. Both academics and shareholder activists have been pushing throughout the 1990s for stronger and more market-based managerial incentives (e.g. Jensen and Murphy 1990). According to Inderst and Mueller (2005) and Dow and Raposo (2005), higher incen- tives have become optimal due to increased volatility in the business environment faced by firms. Cuiiat and Guadalupe (2005) document a causal link between increased competition and higher pay-to-performance sensitivity in US CEO compensation. In the presence of limited liabihty and/or risk-aversion, increasing the performance sensitivity of a CEO's compensation requires a rise in the dollar value of compensation to maintain his participation. However, this link between the level and the "slope" of compensation has not been extensively calibrated. An exception is Gayle and Miller (2005) who estimate a structural model of executive compensation under moral hazard. CEOs of large companies are typically very wealthy individuals. One can doubt that their level ofrisk-aversion and the limited liability constraint represent quantitatively important economic frictions. For this reason, it remains unclear that whether increased incentives can explain the very large increase in CEO pay. Following the wave of corporate scandals and the public focus on the limits of the US corporate governance system, a "skimming view" of CEO compensation has gained momentum. The tenants of the "skimming view" (e.g. Bebchuk et al. 2002) explain the rise of CEO compensation simply by an increase in managerial entrenchment. "When changing circumstances create an opportunity — to extract additional rents either by changing outrage costs and constraints or by giving rise to a — new means ofcamouflage managers will seek to take full advantage ofit and will push firms toward an equilibrium in which they can do so" (Bebchuk et al. 2002). Stock-option plans are viewed by these authors as a way to increase CEO compensation without attracting too much notice from the shareholders. According to them, "high-powered incentives" is just an excuse used by management to justify higher "rent-extraction". A milder form of the skimming view is expressed in Hall and Murphy (2003) and Jensen, Murphy and Wruck (2004). They attribute the explosion in the level of stock-option pay to an inability of boards to evaluate the true costs of this form of compensation. "Why has option compensation increased? Why has it increased with the market? (...) We believe the reason is that option grant decisions are made by board members and executives who believe (incorrectly) that options are a low-cost way to pay people and do not know or care that the value (and cost) of an option rises as the firm's share price rises" (Jensen, Murphy and Wruck 2004). These forces have almost certainly been at work, but it is unclear how important they are for the typical firm. For instance, Rajan and Wulf (2006) challenge the view that perks are pure managerial excess by showing that companies offer high perks precisely when those are likely to be productivity- enhancing. In that spirit, the present paper offers a purely competitive benchmark that explains the rise in US CEO compensation without assuming changes in the extent of rent extraction. In our model, this rise is an equilibrium consequence of the substantial increase in firm size. We also show in an extension how an underestimation by some firms of the real cost of stock-options can affect the wage other firms have to pay.