Why are executives paid so highly

[billvon]

They are currently overpaid, as a class, from an abstract economic pov (what a free and functioning market would set as their pay as a class), at least 5X and probably closer to 12X.

Obviously market forces are not doing that.

Of course market forces do that.

Shareholders demand a hefty return for their investment. If the board can bring in a CEO who is so good that he can guarantee hefty profits, then he is brought in - even if he makes seven figures. If the board does NOT do that, and end up with a sub-par rate of return, the shareholders dump them and elect a new BoD more willing to do what they demand.

Market forces at work.

Likewise, if a new undereducated executive becomes CEO of Wal-Mart and draws a salary equal to his workers, and as a result prices climb, then shoppers will bail instantly and head over to Target, where the well-paid (and effective) CEO is keeping prices low.

Market forces at work.

 

[DaveC426913]

What many people fail to realize is when you hire employees, there is a formula used, in terms of the salary and benefits, being a percent of what the employee earns the company in terms of added value. This puts a limit on how many people you can hire and still turn a profit. Not all positions earn the company the same amount of money, therefore the wage and benefits will not be uniform for all positions. Executives get paid high salaries, not because of a good ole boy network, but because those positions add the most value, with their compensation connected to the same basic formula.

As an example, say you own a factory, with people working along a car assembly line. Each person, on the line, gets paid based on the value added. This is calculated based on what you can sell each car for, and the number of hands that touch the car on the line, and the level of skill at each step, where each adds different value. Next, you have a foreman, whose job is to make sure a portion of line, maintains production and quality. This adds even more value. Since he is in charge of a dozen people, his value is compounded based on the margins he adds to all twelve people. As you go to the top, which may be five or more layers, the CEO, may be responsible for 10,000 people. His ideas will add tiny margins to value of 10,000 people. The value added multiples very fast allowing higher compensation.

Selling also works this way. Those in the field, selling, make a salary and commission on sales. After so many years of good company service, adding value through sales, a good salesman might get promoted to regional sales director. Now that person will be in charge of a group of sales people, who will all give you a cut. This cut is all dependent on you making sure your team is meeting the business sales goals, so all the money adds up for you, your team and company profits. The prestige of your position can often help you team leverage more sales.

The problem with this entire description is that you cannot unambiguously determine how much value a given person adds to a company.
It is not related to how many dollars they actually bring in, since that would result in the salespeople making all the money, and the HR department making zero.

All employees contribute value in their own way. But there is no consistent way of quantifying it. (well ,except for precedent, and some business logic)

So, despite everything you said, salaries are assigned based on an arbitrary (not necessarily fair) assessment of an employee's worth.

 

[billvon]

The problem with this entire description is that you cannot unambiguously determine how much value a given person adds to a company. It is not related to how many dollars they actually bring in, since that would result in the salespeople making all the money, and the HR department making zero.

That is definitely true. All you can do is make your best estimate. If companies make such estimates well, the company prospers. If companies make such estimates poorly, the company fails. So there is some Darwinian process involved, which means that the companies that remain are not completely clueless when it comes to valuing employees accurately.

All employees contribute value in their own way.

Well, no, some contribute no value at all. I've known a few of them. Fortunately, in healthy companies, the vast majority do contribute value.

So, despite everything you said, salaries are assigned based on an arbitrary (not necessarily fair) assessment of an employee's worth.

Agreed. But more often than not, they are at least somewhat fair - because the companies who do it unfairly fail.

 

[DaveC426913]

So there is some Darwinian process involved, which means that the companies that remain are not completely clueless when it comes to valuing employees accurately.

Yes, although the "too big to fail" fiasco showed the world that we shouldn't blindly trust that experts always know what they're doing.

Well, no, some contribute no value at all. I've known a few of them.

Heh. For some, 'none at all' is their own way.

 

[sculptor]

 

[iceaura]

Of course market forces do that.

They aren't doing it, though.

Sure, they should. So something is wrong.

Shareholders demand a hefty return for their investment. If the board can bring in a CEO who is so good that he can guarantee hefty profits, then he is brought in - even if he makes seven figures. If the board does NOT do that, and end up with a sub-par rate of return, the shareholders dump them and elect a new BoD more willing to do what they demand.

Market forces at work.

Likewise, if a new undereducated executive becomes CEO of Wal-Mart and draws a salary equal to his workers, and as a result prices climb, then shoppers will bail instantly and head over to Target, where the well-paid (and effective) CEO is keeping prices low.

Market forces at work.

Those are pleasant evocations of the theoretical fantasies found in elementary economics texts, but obviously fail to describe the rocketing of CEO salaries overall since 1980.

 

[iceaura]

Agreed. But more often than not, they are at least somewhat fair - because the companies who do it unfairly fail.

Is that actually the case with upper level executive salaries?
Obviously, over the long run, if there are companies who do it fairly they should enjoy a long run competitive advantage. But if in a given industry there are no such companies, then no competitive disadvantage exists. So if a mechanism exists to establish overpaying CEOs as an industry standard, then the practice can persist indefinitely, unpunished by market forces.

If companies make such estimates well, the company prospers. If companies make such estimates poorly, the company fails. So there is some Darwinian process involved, which means that the companies that remain are not completely clueless when it comes to valuing employees accurately.

If that were true, the recent enormous bubble in overall CEO compensation would never have happened.

 

[river]

Because they can .

 

[billvon]

Is that actually the case with upper level executive salaries?

By definition, yes - the companies who do that so poorly that they fail no longer exist, and those salaries go away.

Obviously, over the long run, if there are companies who do it fairly they should enjoy a long run competitive advantage. But if in a given industry there are no such companies, then no competitive disadvantage exists.

Until one company does a slightly better job of apportioning salaries. That company prospers. And one company does a slightly worse job; it fails. In industries that have very few companies in the space (I am sure they exist; can't think of any right now) this may take a long, long time.

If that were true, the recent enormous bubble in overall CEO compensation would never have happened.

Why do you claim that? Are you saying that you can not imagine a scenario where a CEO who makes $10 million a year does a better job than one who makes $1 million a year?

 

[DaveC426913]

By definition, yes - the companies who do that so poorly that they fail no longer exist, and those salaries go away.

Until one company does a slightly better job of apportioning salaries. That company prospers.

I think this view is simplistic (not yours specifically, I mean generally). It reads like evolution by natural selection. But selection of this type takes time and occurs in relatively stable periods. (Hang on, don't jump to 'punctuated evolution' just yet).

If evolution is to be the analogy, then I'd say the economy is much closer to fast, dramatic, changes, (such as volcanoes constantly erupting or comet impacts).

The market economy in which we live is far, far too fast changing to support incremental changes. In this kind of "ecology", very marked "mutations" (drastic changes in company strategy) are often as likely - if not more likely - to succeed, than incremental improvements.

I'm not sure if nature has an appropriate analogue of disruptive strategies. (to be clear, I'm not suggesting nature doesn't have its share of aggressively invasive species taking over ecologies, simply that nature doesn't have a mechanism for disruption for disruption's sake).

Companies (populations) are not at the whim of the economy (natural environment); companies are involved in active strategies, often designed to deliberately alter their environment.

 

[billvon]

I think this view is simplistic (not yours specifically, I mean generally). It reads like evolution by natural selection. But selection of this type takes time and occurs in relatively stable periods.

I agree. Lots of things can upset it temporarily, like irrational exuberance over a CEO that had great successes at another company.

The market economy in which we live is far, far too fast changing to support incremental changes. In this kind of "ecology", very marked "mutations" (drastic changes in company strategy) are often as likely - if not more likely - to succeed, than incremental improvements.

In some cases, yes. Disruptive technology shakes up things rapidly. Still, the basics remain. For example, no pure technology company, no matter how disruptive, will survive management so incompetent that they give away all their IP without recompense. And no company will survive mistakes so egregious that they always spend more than they take in. (At least, not for long.)

Companies (populations) are not at the whim of the economy (natural environment); companies are involved in active strategies, often designed to deliberately alter their environment.

Right. But that's no different from nature. Beavers seek to deliberately alter their environment, for example.

 

[DaveC426913]

Right. But that's no different from nature. Beavers seek to deliberately alter their environment, for example.

But the beaver's ultimate preference is to establish a new equilibrium with the environment.
You wouldn't see the beaver deliberately and dramatically altering its strategy to "re-disrupt" the environment once the environment had adapted to the change. That's what I mean by "disruption for disruption's sake".

Maybe the analogy is falling apart.

 

[billvon]

But the beaver's ultimate preference is to establish a new equilibrium with the environment.

?? No it's not. It is to disrupt the environment in its favor. They do not like equilibrium (i.e. an established watershed) and will keep building dams even when there is no need to. Not because they have some plan, but because evolution has given them the programming to build dams, and it's proven to usually work well for them.

BTW all organisms do this. Rats do not "prefer to establish a new equilibrium with the environment" - they eat and reproduce until they die of disease and starvation. Even the yeast we use to make beer will reproduce until the alcohol level kills them or they run out of food, whichever happens first. Then they all die. But in the meantime they reproduce a lot, and that's the goal of life.

You wouldn't see the beaver deliberately and dramatically altering its strategy to "re-disrupt" the environment once the environment had adapted to the change. That's what I mean by "disruption for disruption's sake".

Again, they do that - they just keep building. Not because they like disruption, but because they are programmed to build dams - and building dams disrupts the environment.

 

[DaveC426913]

?? No it's not. It is to disrupt the environment in its favor.

Yes. To reach a new equilibrium. Well, OK, a new stable state at least. Once the dam is built, they won't tear it down again, just to keep the environment ... off-balance.

They do not like equilibrium (i.e. an established watershed) and will keep building dams even when there is no need to. Not because they have some plan, but because evolution has given them the programming to build dams, and it's proven to usually work well for them.

I presume they would make a good attempt to live in their new dammed pond to raise their pups.

 

[iceaura]

Until one company does a slightly better job of apportioning salaries. That company prospers. And one company does a slightly worse job; it fails

Of course the mechanism I postulated would somehow prevent that from happening - that would be its role.

And it isn't happening, as we see.

So if you are correct, and without such a mechanism the sequence you hypothesize is inevitable, we have good evidence for the existence of some such mechanism.

If that were true, the recent enormous bubble in overall CEO compensation would never have happened.
Why do you claim that?

Because it's an enormous bubble in CEO compensation overall - good, bad, criminal, incompetent, production based, failed, successful, all of them - that has had no connection with corporate performance. There has been no Darwinian culling of CEO overcompensation. Look at the banking and financial industry in the US: Even the massive failure of that entire industry led by overcompensated CEOs (based on corporate performance, which was complete failure and bankruptcy directly tied to bad management) did not lead to a proportional culling of compensation just within that industry - let alone in the economy overall.

In fact, one can argue that somewhat the reverse has happened: bad performance of a corporation apparently due at least in part to executive overcompensation (GM, say, or HP) has at times seemed to be used to support even higher compensation among more successful corporations. They are the winners, after all - they deserve bigger money. Seriously, you've seen that argument I'm sure - that the CEO of a winning corporation deserves more money, regardless of how or why they "won" ?

 

[iceaura]

Again, they do that - they just keep building. Not because they like disruption, but because they are programmed to build dams - and building dams disrupts the environment.

Individual beavers will adjust their dam building to circumstance - once they have an adequate dam, meaning there is no more noise of leaking and running water through the place they are trying to plug, they quit building and start piling up food stashes or secondary houses and such. When the noise and small currents return, by holes or diversion, they start again, proportional to the noise and leaks - repair or augmentation. The ones that live along big rivers often build no dams at all.

And so we see that the actual incentives for beavers - the noise and other attributes of shallow, narrow streams of running water, say - are not perverse.* Darwinian evolution culls actual perversity.

Whereas by all appearances executive compensation in the US has become perverse, with overcompensation feeding into itself - we see entire industries, whole facets of the US economy, seemingly designed by executives to maximize executive compensation. It's as if beavers had suddenly developed a programming glitch, and become actually motivated by the desire to build dams - the bigger the better. We would soon have useless towering piles of sticks and mud all over the place, and many fewer beavers.

*In their natural environment. A beaver kept as a pet in a house with a leaky toilet may end up chewing mop handles into appropriate lengths and shredding the family's shoes for wadding, in a futile attempt to shut off the noise by plugging the commode - but that just means they aren't in the right place, not that Darwinian culling would be appropriate, or that there's anything wrong with the adorably cute little daughter-beloved and amazingly industrious house rodents.

 

[DaveC426913]

Whereas by all appearances executive compensation in the US has become perverse, with overcompensation feeding into itself - we see entire industries, whole facets of the US economy, seemingly designed by executives to maximize executive compensation. It's as if beavers had suddenly developed a programming glitch, and become actually motivated by the desire to build dams - the bigger the better. We would soon have useless towering piles of sticks and mud all over the place, and many fewer beavers.

Great explanation of what I was trying to say.

Individual beavers will adjust their dam building to circumstance - once they have an adequate dam, meaning there is no more noise of leaking and running water through the place they are trying to plug, they quit building and start piling up food stashes or secondary houses and such. When the noise and small currents return, by holes or diversion, they start again, proportional to the noise and leaks - repair or augmentation. The ones that live along big rivers often build no dams at all.

And so we see that the actual incentives for beavers - the noise and other attributes of shallow, narrow streams of running water, say - are not perverse.* Darwinian evolution culls actual perversity.

*In their natural environment. A beaver kept as a pet in a house with a leaky toilet may end up chewing mop handles into appropriate lengths and shredding the family's shoes for wadding, in a futile attempt to shut off the noise by plugging the commode - but that just means they aren't in the right place, not that Darwinian culling would be appropriate, or that there's anything wrong with the adorably cute little daughter-beloved and amazingly industrious house rodents.

And son of a gun, now I know what stimulus drives beavers to build dams.

 

[billvon]

Individual beavers will adjust their dam building to circumstance - once they have an adequate dam, meaning there is no more noise of leaking and running water through the place they are trying to plug, they quit building and start piling up food stashes or secondary houses and such.

Ah, now you've hit upon the fundamental problem - "meaning there is no more noise of leaking and running water." That works most places, not in other places. In a river valley, you might well have a population of beavers that builds until the valley is dammed, and then they reduce their efforts because almost all the flow has been impounded. Until the spring, when the flood breaks big holes in the dam, and then they have to rebuild. Works great.

But if there are no periodic floods and no valley walls? You get absurd, perverse dams, like the half mile long, 14 foot high dam in a swamp (with very slow moving water) in Alberta. They just keep building because they hear running water at the edges, and they do that no matter what the consequences. Is this because they hate the swamp, or do they WANT to build the world's longest beaver dam? Do they want to hose all the other swamp animals who do not want 14 feet of water in their habitat? No, they are just using a set of instincts that have served them well in the past.

And so we see that the actual incentives for beavers - the noise and other attributes of shallow, narrow streams of running water, say - are not perverse.* Darwinian evolution culls actual perversity.

And in most cases works well.

Whereas by all appearances executive compensation in the US has become perverse, with overcompensation feeding into itself - we see entire industries, whole facets of the US economy, seemingly designed by executives to maximize executive compensation. It's as if beavers had suddenly developed a programming glitch, and become actually motivated by the desire to build dams - the bigger the better.

Which is exactly what they do when they hit something they're not used to, like a flat swamp with slowly flowing water. (It's currently 14 feet high and over half a mile long - and they are still building.)

Likewise, the purely capitalist approach usually works for companies choosing talent. They choose talent that provides the best bang for the buck. Sometimes that's minimum wage for someone whose most valuable talent is emptying trash cans. Sometimes it's $100K a year for someone who can manage 100 of those people and make sure the cans get emptied everywhere on a large campus. Sometimes it's $250K a year for someone who can crank out two valuable patents a year. Sometimes it's $1M a year for someone who can organize a division that cranks out 100 valuable patents a year - and then can sell that IP for billions. All the above are good (not perverse) decisions from the point of view of the company and its investors.

But sometimes that system fails. Sometimes they spend $1M a year on a guy who just does a good job selling himself, and then drives the company into the ground. Sometimes they spend $50K a year on the guy who can crank out two valuable patents a year, and he gets tired of that and moves on to a better paying job - and gets replaced by someone who can write great TPS reports and that's about it.

Needles to say, there are many ways in which beavers are NOT like corporations of people, so the analogy doesn't work very far. But to the extent that both share a simple drive that _usually_ works - but sometimes fails spectacularly - they are similar.

 

[iceaura]

But if there are no periodic floods and no valley walls? You get absurd, perverse dams, like the half mile long, 14 foot high dam in a swamp (with very slow moving water) in Alberta

Nothing perverse about that - nice big pond, many little beavers with happy homes, kids don't have to wander for miles to find a new home, shoreline is long enough to allow regrowth of the near shore candy aspen(? guessing) between gnawdowns, beaver heaven being created one step at a time.

Needles to say, there are many ways in which beavers are NOT like corporations of people, so the analogy doesn't work very far. But to the extent that both share a simple drive that _usually_ works - but sometimes fails spectacularly - they are similar.

One difference being pointed to is that the failure here, to curb damaging and irrational bubbles in executive compensation, is not "sometimes" but predominating.

 

[billvon]

Nothing perverse about that - nice big pond, many little beavers with happy homes, kids don't have to wander for miles to find a new home, shoreline is long enough to allow regrowth of the near shore candy aspen(? guessing) between gnawdowns, beaver heaven being created one step at a time.

If you are into big dams, then no worries. From the point of view of "what is normal" it certainly is perverse, and kills an awful lot of animals and plants that were relying on shallow water swamps. But that's nature; it's not fair. It just is.

If you are into big salaries for CEO's, nothing wrong with that either. Nice big bank account, big contributions to charities, lots of income tax to support federal and state programs, money into the local economy, heaven for nearby real estate brokers, maid services and landscapers. Heck, that CEO might put a dozen kids through college with local wages alone. It's certainly perverse in that it's orders of magnitude more than others make. But that's capitalism; it's not fair. It just is.

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