28 February, 2008

Don't hate the CEO, hate the game

Megan McArdle says,
Some CEOs really are nearly that brilliant; it's not an exaggeration to say that without Steve Jobs, Apple would currently be a not-very-profitable division of Xerox. Some are really dreadful, driving their companies into the ground while collecting a ton of money from the shareholders.
In other words, adverse selection means many a CEO is grossly underpaid.

2 comments:

JD B said...

Is it possible that many CEO's are paid the optimal amount, and the rest are over paid? I don't think that just because some CEO's are overpaid means that others are therefore underpaid. Are there just as many $$ being over paid as underpaid?

What is the economic rule that would lead you to your conclusion? I ask because I'm sure that, compared to your professors, mine are grossly overpaid for the education they are providing for me!

I can see that overpaying and underpaying leads to market inefficiencies. Can the inefficiency exist in only one direction from the optimal, or does it have to exist in both directions?

I think it is very likely there are CEO's being underpaid, but I don't think it has any relationship to other CEO's being overpaid.

KLR said...

The short answer is: no, what you are proposing cannot be the case.

For the best CEOs to be paid what they are worth and the bad CEOs to be overpaid it would require (1)being able to distinguish the good from the bad, and (2)having isolated the bad CEO’s, being stupid enough to pay them more than they are worth.

Clearly, a board can observe something about potential performance before hiring, but the quality of candidates is largely a crap shoot. So a board can only pay a CEO his or her expected value. Expected value is just a weighted average; the consequence is some CEOs are overpaid and some are underpaid. In econo-jargon this is adverse selection.

If you still don’t buy the argument, consider the decision to hire 10 workers to rogue an onion field. Suppose five are good workers and five are bad. If you think you are paying the five good workers what they are worth and overpaying the five bad workers, then you are either making an incredibly bad business decision or you are, in fact, underpaying the good workers.