One idea you hear floating around these days is that nobody really "needs" to earn $1 million a year or more. So there's really no argument for continuing to allow the very large pay packages that CEOs typically earn. It's a bit of a variation on the old quote by Marx --- something about "to each according to his needs."
I have a couple of responses to this point, and I'll focus on one of them today.
This argument --- that no social purpose is served by allowing CEOs to earn large sums --- ignores the role of matching in the managerial labor market.
What do I mean by this?
One problem we face in the economy is getting the right employees working for the right firm. Think about all the resources that are expended in job interviews and applicant screening. It's important, in most firms, to get the right employees; that is, to get the employees that are going to help the firm create the most value. And the same is true for CEOs.
Think about the following example: Jimmy the CEO is a pretty good CEO for the ABC company. Let's suppose that if ABC employs Jimmy, then the firm's profit (gross of Jimmy's salary) will be higher by $1 million than the profit would be if the firm employed its next best CEO. Let's also assume that jobs and profits are positively related (which they often are but sometimes aren't). If ABC employs Jimmy then the firm will create 100 additional jobs, compared to what would happen if ABC employed its next best CEO.
But Jimmy the CEO is no one-trick pony.
Let's suppose that XYZ company also wants him. And let's suppose XYZ's profit will be higher by $2 million (again gross of Jimmy's salary) and its jobs higher by 200, again compared to the case where XYZ employs its next best CEO.
Now... Where should Jimmy work?
Both profits (for Wall Street) and jobs (for Main Street) are highest if Jimmy works at XYZ, not ABC.
But suppose there's a government-mandated cap on CEO pay; the most Jimmy can be paid is $500,000. And let's also suppose ABC makes Jimmy a job offer with a half million dollar salary. What should he do?
He can't do any better by waiting around for another offer. So he might as well take it. Jimmy ends up working for ABC. And 100 jobs and $1 million in profits are lost as a result.
Now let's suppose that Jimmy's pay isn't capped.
ABC offers half a mil. Jimmy thinks "Oh, that's plenty. I'll take it." But then XYZ counters with $750,000. Jimmy thinks "Cool, now I can get a bigger boat!" And ABC counters with $900,000. XYZ finally wins the bidding with an offer of $1,000,001. ABC is not willing to match this offer, because it earns higher profits when employing its next best manager, rather than paying Jimmy that amount.
So Jimmy gets richer under this arrangement. But that's not the only thing that happens. More overall profit is created (some going to shareholders and some to Jimmy), and that money can be reinvested in other socially valuable activities. And more jobs are created too. All because the bidding didn't just change what Jimmy was paid, it changed where he worked.
This is related to Hayek's ideas (which I have discussed before) about how prices convey information. People tend very much to focus on the role of wages --- which are just a "price" in a labor market --- in determining who gets rich and who doesn't. But wages also communicate information about socially valuable career choices. And that's what's going on here.
My example is just, well, an example. There's no reason to think that this describes everything about the managerial labor market. But this effect is potentially important, and we'll at least want to think hard about this effect before legislating pay caps.
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2 comments:
One small flaw with your idea of Company XYZ and ABC is that there really is no good way to be sure that CEO #1 will make the company one millon dollars richer and CEO #2 only 500,000 dollars. You can guess that they did well at Company GHI and that they're a smart person, so maybe they'll do well, but the last 6 months have certainly seen plenty of companies run by smart guys who are probably fairly competent that completely tank.
It's true that hiring decisions are never made with the certainty in the example. But this doesn't change the basic point: Prices facilitate matching.
Let's suppose that firms don't know for sure which manager will be best when hiring. Let's also suppose that it's possible for them to gather information that will help them make a better decision (by, for example, checking references, doing day-long interviews, etc).
Let's suppose at the end of that process, ABC concludes that Jimmy is likely to be better than their alternative manager, but not by that much. They want him, but they aren't willing to break the bank to get him. XYZ concludes that Jimmy is likely a really good fit, and they think it's highly probable that he's just what they need. They really want him.
There are no guarantees, of course, but based on the best available information, the best decision (for society) is for Jimmy to work at XYZ.
A wage cap could leave Jimmy at ABC, and that would be bad.
Or course it could turn out that Jimmy is better at ABC than at XYZ, but the criteria for judging decisions should be that the decision makes best use of information that's available at the time of the decision.
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