Paying People Too Much
by Dr. Elliott Morss
In 1990, Donald Pels, the chief executive officer of LIN Broadcasting, made $186.2 million by cashing in stock options when LIN was bought by another firm. Steven Ross, the head of Warner Communications, walked away with a $74.9 million cash “bonus” when his firm merged with Time Magazine. Stephen Wolf of United Airlines was at the top of the “regular” compensation list when he took home $18.3 million (1990 was a year in which UAL profits fell by 71%). Business Week reported that chief executive officers of large U.S. firms were paid an average of $1,925,806 and that the spread between this group and other labor groups widened during the 1980s (“The Flap Over Business Pay”, Business Week, May 6, 1991, pp. 90-112). Another study estimates the average chief executive officer of a major U.S. firm makes 160 times what the average American makes (Graef S. Crystal, In Search of Excess: The Overcompensation of American Executives, New York: W.W. Norton & Company, 1991.
Today, heavyweight boxers participating in a championship fight will each take home $25 million, with their promoters earning similar amounts. The average major league ballplayers makes $800,000 annually, while Michael Jackson and Bill Cosby easily clear $20 million each year. Arnold Schwarzenegger made $32 million in 1990 by starring in two movies: Total Recall and Kindergarten Cop. Is it not dumb for us to tolerate a system that allows people to make these amounts when:
- engineers average less than $50,000 annually;
- school teachers earn $32,000;
- General Norman Schwarzkopf’s annual salary for managing 250,000 military personnel in Desert Storm was $103,927.60 .
Should we be concerned enough to take action? Many thoughtful people are disturbed by the size of these payments. Professor Edward E. Lawler of the University of Southern California’s Graduate School of Business says: “It seems to get more absurd each year. What is outrageous is that one year becomes the standard for the next. And no one is in a position to say no.” Graef Crystal, an Adjunct Professor of Business at the University of California, Berkeley and a longtime business consultant, calls the executive pay system “rotten to the core”.
The standard Chamber of Commerce reply is that we should not “mess with the market” because whatever its weaknesses, it is a better overall allocator of resources than any other system ever devised by man. While this latter assertion may be correct, we believe these issues should be explored. We will:
- investigate how such egregious differences in pay come to happen;
- develop criteria for times when interventions might be appropriate;
- consider alternate forms of intervention.
We will focus almost exclusively on payments for services and not goods. Of course, there are many goods that are overpriced. Note also, we will not be talking about people who make a fortune by selling companies they founded: such persons are not getting paid for personal services. Instead, they are being rewarded for taking chances as entrepreneurs.
Two criteria come immediately to mind that can be used to determine whether people are overpaid:
- The market test: is there competition, and if so, is the person earning his or her marginal value product? In less technical terms, is a person getting compensated in a manner that reflects his or her contribution to the profits of an enterprise? If the person provides services to a non-profit organization or a government, the question is how much higher are the additional social benefits provided by the entity as a result of the person’s services.
- Social: There is a point at which a large segment of society views the amount paid to an individual for services rendered so large as to be obscene, outrageous and simply not to be tolerated. This feeling might be caught in a quote such as the following: “I don’t care if the market is working; from a societal standpoint, those payments are obscene; there is something wrong with the market mechanism if it allows somebody to make that sort of money when a school teacher only makes $32,000”. Such payments can cause anger and envy which can generate further social costs.
In the following sections, we will apply these criteria to two groups, senior executives and media performers, and investigate their consequences.
i. The Market Test
It is clear that by the market test, a large number of senior executives are overpaid. Empirical verification of this will be undertaken by correlating their payments with long term performance measures of their companies (in what we write, I will make these correlations using Business Week data; more specifically, I will regress personal service payment on size of firm as measured by sales and return on equity; I will also correlate the change in compensation in the 1988-90 ).
Why has the market broken down? There are many reasons for market imperfections. Here, we will focus on two. First, there are certain “assets” one must have to be considered for the senior executive “club” by large corporations and the “headhunter” firms that work for them. Social and professional networks are two of the more important assets given consideration. By limiting searches to persons with certain assets, competition is limited, and thereby allow candidates with the proper assets to charge more for their services. Unfortunately for stockholders, these characteristics do not accurately identify who can work effectively as senior corporate executives (this will be demonstrated by the weak correlation between payments and corporate performance).
Second, collusion between the senior executive and the firm’s board of directors occurs. Business Week reports that in a recent survey by Korn/Ferry International of 352 companies, the average director of these companies collected retainer and meeting fees of $32,352. Some pay much more: Pepsico, Philip Morris, and Coca-Cola pay $78,000, $54,675, and $53,400, respectively. In theory, these directors represent the interests of shareholders. In fact, these directors are normally selected by the Chief Executive and are likely to support his or her recommendations on most matters. And even if the Chief Executive does not make a recommendation on what his or her compensation should be, it is reasonable to think that under current arrangements, directors will make quite generous offers.
But even if the market were working properly in awarding senior executives “what they were worth”, are there not some longer term social costs that should be considered? In 1990, the heads of the “big three” American auto companies took home between $8 and $12 million, and there were numerous others operating out of the executive suites of these companies that took home considerably more than $1 million. It is hard to believe that such compensation does not have a damaging effect on company morale. Consider two cases: a senior engineer and a production worker:
- A senior engineer is critical to the success of an automobile company because s/he is responsible for the mechanical design of the company’s vehicles, and s/he knows it; s/he might make as much as $300,000; how must he or she feel about having to report to a group in the executive suite making ten times more?
- A production worker with seniority knows a lot about the automobile industry. Can s/he be expected to believe there is someone in the executive suite who is more than 100 times as productive as s/he?
Is it reasonable to expect that the senior executives, technicians, and production workers in a firm with such differentials will be disposed to work together as a tightly-knit team?
Another important social question warrants attention:
Should anyone get paid these amounts? Do we want anyone in our society to receive so much more than they will ever be able to use in a reasonable manner? We are concerned about destroying incentives to work and make risky investments. Perhaps $10 million is okay; but how about the $186.2 million payment to Donald Pels or $78.2 million to Steven Ross?
i. The Market Test
On first blush, sports and other media people seem to get paid “what they are worth” by the market. After all, the public pays fairly directly to enjoy their performances. But is the market really working properly? How about the argument that the media makes stars out of not-too-exceptional people. If that is the case, stars are overpaid in the sense that their intrinsic qualities do not exceed those of others who cannot charge as much for their services. This would not be possible if the market was working. Why? Because through the competitive process, all performers would be judged and paid in accordance with their talents. But is the media competitive?
We know the broadcast media cannot be completely competitive because the number of airwaves is limited and because of the high costs of getting into the business. However, it is still possible that the best get to the top if the process of sorting that takes place before media involvement is competitive. Let us consider a concrete example drawn from heavyweight boxing:
Most of the money made from big-time boxing events comes through pay-TV. Mechanisms have been developed for cable-TV by which the audience can be charged on a per event basis, but only a few cable-TV stations are set up to employ them. One of the biggest is owned by the Time-Warner conglomerate. They have an audience of 20 million sets hooked up. To give some sense of the numbers, when Holifield fought Foreman (Holifield was the heavyweight champ while Foreman was a popular contender), they had an audience of 7% that got charged $35 to watch the fight, generating a gross of $49 million. The rule of thumb is that the boxers get 50% of the gross with the remainder going to the promoters, out of which they have to pay all costs. For a Holifield-Tyson match, estimates are they would get a 20% audience, generating a $140 million gross.
Time-Warner has effectively “bought” Holifield in that it gets to show any of his fights on their pay-TV system. Time-Warner tried to “buy” King and all of his fighters, including Tyson, but King chose to set up his own pay-TV network. While everything is at some level negotiable, the tradition is that the Champion’s promoter gets to produce the fight. Consequently, with Holifield the champion, the fight will go out over the Time-Warner system; if Tyson beats him, the next fight will be shown on the King system.
What does all this mean? In a nutshell, the promoter is earning an excessive profit because s/he has access to the airwaves which are in limited supply. If competition was introduced among promoters, their payments would come down dramatically, and some of that would probably go to the performers in even higher payments.
The Unique Performer: Myth and/or Reality?
The question now becomes whether we have two performers who are intrinsically so unique that the public is willing to pay a huge amount to see them perform. Incidentally, this question can be generalized across all performers. Consider two possibilities:
- there is a small group of performers that are simply better at what they do than any others in their field; the public knows this and is willing to pay a substantial premium to see the very best perform; the electronic media allows them to register this demand by paying for these performers to come into their living rooms;
- the media operates as an oligopoly and limits competition: it chooses individuals that are not uniquely endowed and convinces the public that they are simply better at what they do than any others in their field; in short, it creates these people: Krugman is made a superstar in economics (because the New York Times regularly quotes his opinions) just has Holifield, Tyson, Pavarotti, Roger Clements, Frank Sinatra, Madonna, and Tom Brokaw are media creations.
Knowing which possibility fits the facts is important: if the first is correct, the market is functioning properly and our dislike of what media performers they are getting paid has to be registered on social grounds; if the second is possibility is the correct one, their high pay results from a market imperfection.
Our conclusion is that there is an element of each (uniqueness and fabrication) associated with most highly-paid performers. Regarding the former, there are more and less competitive review processes that performers must go through before the media is interested in promoting them into something “bigger-than-life”. In sports, the processes are quite competitive: Tyson must be a good boxer and Clements must be a good baseball player to get to where they are today. At the other extreme, there are persons who are almost completely media creations: Hollywood does create mystical superstars out of some pretty ordinary people.
Perhaps the media causes us to focus excessively on the superstar: there are many local performers who are also excellent. However, most people will pay a premium to see the very best in a particular field. For example, if a performance involves something one knows very well, one will often pay a premium to see the best in the world perform. If, on the other hand, the performance is in an area that one knows little about, a performance by the best in the world can be wasted in the sense that one does not know enough to be able to see the difference between the super-star and local performer. Consider two concrete examples: tennis and boxing. If one is a true student of tennis and one would not be at all interested in watching a club tennis tournament unless there was a social reason to do so: the players are mediocre; however, one would be interested in watching the best tennis players in the world play: they do things one simply can’t even imagine doing. Assume one is not a student of boxing; this means one cannot distinguish between a good and bad boxer. Hence, a championship fight would be wasted: one could get just as much out of watching a club match.
However, there is one other important situation to be considered that causes people to prefer the superstar to the local performer: some people derive great satisfaction (for various reasons) from being present at an important event, even if they know nothing about the event. For example, most of the people that frequent our major symphony halls know little about music: instead, they like the settings, and they make appearances for social reasons. For some people, the same is true for the World Series, Wimbledon, the Superbowl, etc.
Dumb Things Analysis
In the above paragraphs, we have used two analytic criteria to determine why senior executives in the corporate world and media performers are paid excessively. And while there is some overlap, the results came out differently for the two groups. In the case of senior executives, it appears that the market has not functioned properly in the sense that senior executives have been able to isolate themselves from the persons to whom they should be accountable – the stockholders. In the case of the media performers, it appears that for the most part, the market is working pretty well: media performers are being paid astronomical amounts because modern communications technologies permit beaming their performances to individuals and charging directly for them.
Let’s start by offering suggestions to deal with the breakdown in accountability between the senior executives and their shareholders which permits the former to pay themselves excessively and get away with it. The first thing is to strengthen stockholder representation in compensation decisions. There are several actions needed here:
- first, get the Securities and Exchange Commission (SEC) to allow stockholders to have a say in senior executive compensation decisions: under present regulations, the SEC does not permit stockholders to determine executive remuneration on grounds that it constitutes “ordinary business”;
- second, there is need for stronger public interest stockholder associations; recently, the United Shareholders Association put out a study that identifies “black-hat” CEOs who collect too much pay for too little performance; perhaps a regular publication is needed having the same format as Consumer Reports to report on matters of interest to stockholders (Stockholder Reports [?]);
- third, major investors, such as government retirement funds, should be pressed to play a stronger role in corporate decisions; already, the California Public Employees Retirement System is questioning executive pay;
- fourth, corporations should be pressed to consider establishing ratios between their highest and lowest paid employees; Plato suggested a 5 to 1 ratio; Peter Drucker proposed 20 to 1; in Germany, the average rate is 21 to 1; in Japan the average is 17 to 1 whereas in the United States, the average is a mind-boggling 85 to 1!
The second need is to get Directors to do what they are supposed to do – represent stockholders’ interests. Several suggestions can be made here:
- get shareholders to determine directors’ pay, rather than having directors themselves or senior executives making these decisions; (in addition to receiving extremely generous compensation, 67 of 100 largest US firms provide retirement plans for directors);
- presently, directors usually rubber stamp compensation recommendations made by management; directors should be allowed to hire their own pay consultants to review these recommendations;
- perhaps there is nothing that would make directors think more in terms of the interest of stockholders than to make most of their compensation take the form of stock and require them to hold it in this form until they resign their positions.
Let us turn now to the problem of people getting paid excessive amounts from the standpoint of our social values. While we have to be concerned about destroying work incentives, is there not an annual level of compensation that provides adequate incentives above which society deems the payment excessive. For the sake of a concrete example, consider an annual compensation limit of $7.5 million adjusted annually for increases in living costs. Can anyone claim that this does not provide adequate incentives for executives to work and performers to perform? And even if, as an athlete or other type of performer, your professional life is extremely short, you can live reasonably well on the annual interest and dividends provided by one year’s work at a $7.5 million rate (Invested conservatively, $7.5 million should provide $375,000 after tax without drawing down capital ).
If society could agree on an upper limit, it would be reasonably easy to implement. The personal income tax was instituted because it was seen as the best measure of taxpayer’s ability to pay. To implement this suggestion would involve imposing a 100% marginal rate on any annual earnings that exceeded society’s upper limit. Introducing this rate would mean the government would collect all of a person’s annual payments in excess of $7.5 million.
There is a slight complication: the price charged for a performer’s services is usually based on what the promoter estimates the market will bear and not on what the performer will take home after taxes. Consequently, introduction of the 100% rate would normally mean the promoter or some other party to the performance would pocket what the performer might otherwise earn. To avoid this outcome, the performer should be allowed to collect payments in excess of $7.5 million without paying it all to government providing s/he donated the excess to worthy causes. Such a regulation would motivate the performer to collect all s/he could for his services so that a middleman would not get a undeserved windfall payment.
It is clear that because of limited entry, there is a monopoly profit being made by the promoter. If there were more promoters, they would bid down the price for promoting the fight. This would probably mean the fighters would get paid more. Let’s be more specific on this point: if the demand curve is perfectly elastic (meaning the public is willing to dole out a fixed amount for the fight), the revenues given up by the promoters as they bid down their share of the gross will go entirely to the fighters. Take the other extreme: if the demand for the fight is totally inelastic (the public will pay any price to see the fight). Assuming the demand curve is downward sloping and assuming the promoters correctly set the price ($35) to maximize the gross take, two extremes are possible, depending on the shape of the fighters’ supply curves. If they are totally elastic, (they will fight for a fixed price), there will be no increase in their take as the promotion industry becomes more competitive. If their supply curve is upward-sloping, they will collect some of the gross foregone by the promoters. As suggested above, the most likely scenario is that with increased competition among the promoters, the fighters’ take will go up.