Executive Pay and Firm Size in the Presence of Career Concerns and Labor Market Competition

Abstract

We exposit an integrated agency model of multi-period career concerns and labor market equilibrium with managerial reservation utility levels, and thus pay levels, determined endogenously for firms of different sizes. Stochastic managerial talent takes two forms: a manager drawn from a tighter talent distribution with a higher mean is ipso facto more talented. Managerial talent enters into a nested stochastic production function that encompasses an agency model with a manager that responds to effort incentives and a multiplicative talent assignment model with the most talented manager assigned to the largest firm. Effort incentives are redundant in the assignment specification. Utilizing observations from a long time-series of S&P 1500 companies, we estimate this function describing the incremental wealth created by the manager as a function of “effort”, latent raw “talent”, idiosyncratic firm risk (asset volatility) and the opening value of assets employed. Our empirical findings support the agency specification such that incentives matter rather than the assignment specification. We show that CEO talent affects the marginal productivity of the firm at approximately twice the rate as effort. Since asset volatility is also more subject to scale effects than effort, risk per marginal product of effort is higher in larger firms. Due to the cost of compensating managers for risk, pay-performance sensitivity optimally declines with size given the empirical parameters that we estimate. We believe ours to be the first to explain this well-established empirical fact. Furthermore, our talent estimates explain much of the increments to real CEO pay levels and income over recent decades as a response to increases in talent and as compensation for higher risk borne by executives, with firm size growth playing a negligible role. The explanatory power of talent and risk is high with an R2% 82% in the model explaining increments to pay. Our estimated talent distribution is largely uncorrelated with firm size. We also identify the most talented CEOs who earned enterprise returns 17 times higher than the CEOs of the largest firms.

Keywords: CEO pay, firm size, track-record, talent, principal-agent

JEL Classification: G34, J41, J44, L25