CEO Compensation: A Demand = Supply Model


Calpundit challenged the presumption that the 7X increase in (nominal) CEO compensation since 1980 can be explained by a demand = supply model.  AB thesis suggests that the increase is explained by factors that deviate from the traditional model.  My comments will be limited to the traditional model after I note that in real terms compensation has risen by a factor of 3.5X as prices have approximately doubled.  Of course, employee compensation has risen by a 1.3X factor if also expressed in real terms. 


The profit-induced demand curve shift rests on the notion of higher corporate profitability.  Indeed, real corporate profits have risen by 2.7X.  Note, however, that the ratio of CEO compensation to corporate profits is up by 1.3X, which happens to equal to the TOTAL increase in labor compensation even though labor productivity has also risen over this period.  So unless CEOs were severely undercompensated in 1980, the simple profits-induced demand curve shift cannot fully explain the increase in CEO compensation.


Five years ago, a more advanced version of this explanation rested on the presumption that an anticipated explosion of future profits was leading to both higher stock valuations and high CEO salaries.  This model, however, would have predicted a decline in compensation with the stock market bust.  The declining stock market, however, was accompanied by ethics controversies resulting in Sarbanes type changes in the regulatory environment.  So one could argue that the supply curve has shifted inwards.


Calpundit also wonders why the CEO supply curve seems so inelastic.  One could challenge any presumption to know the elasticity of a supply curve that may have shifted but the Michael Jordan levels of compensation would lead most to conclude Calpundit’s query is legitimate.  One might argue that it takes years to garner CEO skills but this explanation belies the fact that CEO salaries have been very high for many years.


The only hope I see for the traditional model rests in the pyramid type models that are often used to explain salaries of superstars such as Michael Jordan or maybe even Michael Vick.  OK, Dick Cheney cannot run like Mr. Vick but the superstar model does beg the question what the virtual quarterback of Halliburton brings to the table.  Does not the abilities from government contracts, ability to navigate K. St. lobbying, procurement rules, tax laws, and accounting regulations create substantial value marginal product (VMP)?  And the rise in a CEO’s VMP might be proportionately greater than the rise in profits if corporations can manage to earn profits in excess of the VMP of capital.  Finally, the ability to generate additional returns under crony capitalism may go well beyond what one can learn from an MBA program.