Wednesday, October 5, 2011

Market Efficiency

For a long time now I have been hearing about how markets set salaries based on the productivity and value of an employee. The ideal was that increases in executive pay were a function of the greater influence a top executive could have in the information age. It was a nice story. Unfortunately, it also seems to be untrue:

Companies have long hid the way they set executive pay, but in late 2006, the Securities and Exchange Commission began compelling companies to disclose the specifics of how they use peer groups to determine executive pay.

Since then, researchers have found that about 90 percent of major U.S. companies expressly set their executive pay targets at or above the median of their peer group. This creates just the kinds of circumstances that drive pay upward.

Moreover, the jump in pay because of peer benchmarking is significant. A chief executive’s pay is more influenced by what his or her “peers” earn than by the company’s recent performance for shareholders, according to two independent research efforts based on the new disclosures. One was by Michael Faulkender at the University of Maryland and Jun Yang of Indiana University, and another was led by John Bizjak at Texas Christian University.

As Kevin Drum observes:

Adjusted for inflation, cash compensation for line workers has actually decreased over the past few decades, and even when you include healthcare compensation it's grown only about 30% or so. In contrast, executive compensation over the same period has more than quadrupled.

This is clearly a result of market failure. It also suggests that the reasons for increases in executive compensation are entirely due to poorly designed compensation system and not because of market forces. Examples like this one are worth keeping in mind when considering whether a market-based outcome is really utility maximizing or not.

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