Why Has CEO Pay Increased so Much?
30 Pages Posted: 17 May 2006
Date Written: March 14, 2006
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. The marginal impact of a CEO's talent is assumed to increase with the value of the assets under his control. 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 the cross-sectional Cobb-Douglas 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 five-fold increase of CEO pay between 1980 and 2000 can be fully attributed to the increase in market capitalization of large 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.
Keywords: Executive compensation, wage distribution, Pareto distribution, wage inequality, assignment, incentives, pay performance sensitivity, human capital
JEL Classification: D2, D3, G34, J3
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