Higher Rock Education - Economics Blog

Wednesday, October 12, 2016

I am amazed when I read about CEOs who are paid $10s of millions or even over $100 million. Are they really worth that much? I consider myself a free market economist, so I would never deny them the right to earn that much if someone is willing to pay them; but I confess I wonder how their salaries can be justified.

In general I am in favor of minimizing the size of government, so I was supportive of private firms contracting with the government to run our prisons and schools. However, I am reconsidering this position after reviewing the research by Drs. Hart and Holmstrom which raised concerns related to structuring contracts to provide proper incentives.

Oliver Hart and Bengt Holmstrom won the Nobel Memorial Prize in Economic Science Monday for their work on contract theory. Economic contract theory focuses on the incentives and risks of contracts. Much of their efforts were on misplaced incentives in contracts with top management and privatizing industries that have been traditionally public institutions. Dr. Hart is British, and now is a professor at Harvard. Dr. Holmstrom is Finnish, and teaches at MIT.

It is essential that buyer and seller, employer and employee, agree to the terms of their transaction. Many agreements require a contract. A contract is a legal agreement that defines the terms two parties agree to. Normally they include a price, (the price of a car you are purchasing), the term (how long you can stay in your apartment), and the conditions of the sale (such as all the disclaimers you see if you actually read what you agree to when you download an app on your smart-phone). The ideal contract is mutually beneficial without any conflicts of interest.

Few would deny the power of incentives. Parents use rewards and punishments as incentives to persuade their children to do their homework or perform their chores. Yet some contracts provide incentives that are inconsistent with the objectives of both parties. For example, the compensation of many CEOs have provisions that are not tied to a company's performance. For example, firing a manager may prove very costly if he has a "golden parachute". Stanley O'Neal received $161.5 million when he left Merrill Lynch following a $2.3 billion quarterly loss. Later the government fined Merrill Lynch $8.4 million for actions related to the sub-prime mortgage market. Hewlett-Packard was criticized when Presidential candidate Carly Fiorina received $40 million when she was asked to leave in 2005 following a $50 drop in HP's share price between 2000 and 2005. In each of these cases and many others, the severance package was not tied to the company's performance.

MSCI concluded in a study that CEO pay has not reflected stock performance. In their executive summary they write:

Companies that awarded their Chief Executive Officers (CEOs) higher equity incentives had below-median returns based on a sample of 429 large-cap U.S. companies observed from 2006 to 2015. On a 10-year cumulative basis, total shareholder returns of those companies whose total summary pay (the level that must be disclosed in the summary tables of proxy statements) was below their sector median outperformed those companies where pay exceeded the sector median by as much as 39%.

For long-term institutional investors, this potential misalignment of interests between CEOs and shareholders may undermine the adoption of equity-based incentive pay that has dominated executive pay practices in the U.S. for the past three decades. During the observed period, long-term incentive pay was the largest element of CEO pay, accounting for more than 70% of compensation for both summary pay and realized pay (which incorporates stocks gains realized during the course of the year), according to our calculations. MSCI

Dr. Holmstrom concluded that companies should structure their contracts to reward employees after performance can be measured. Large severance packages would reward exceptional performance. Furthermore, compensation should be tied to a company's stock performance relative to other firms in the same industry. A CEO should not receive an added performance bonus when the company benefits from a growing market. For example, assume the economic environment is conducive to growth, and Company X's share value increases 10%. The share prices of other companies in the same industry grow 20%. Company X's performance bonus should reflect that the company did not perform as well as its competitors. It is also unfair to punish an executive for failing to live up to expectations when circumstances were beyond his control.

Dr. Hart explored the idea of incomplete-contract theory. When describing the importance of his work, the Academy said, "His research provides us with theoretical tools for studying questions such as which kinds of companies should merge, the proper mix of debt and equity financing, and which institutions such as schools or prisons ought to be privately or publicly owned".

A contract is incomplete because it cannot anticipate every circumstance, yet most contracts define what a person should do, rather than how decisions should be made. His work explored who should be given the decision making authority.

Businesses and governments must reach decisions on when to subcontract with firms to reduce costs. When they do, they relinquish some control because not all situations can be anticipated. Recently there was a movement to privatize the management of prisons. The primary objective was to cut costs without sacrificing quality. Hart's research underscores the importance of the contract between the management company and the government if quality of service is not to suffer. Hart concluded that the incentive to cut costs was too high and the quality of service deteriorated. The U.S. Department of Justice recently discontinued using private prisons after a report concluded conditions were worse than government run prisons.

To learn more about Drs. Hart and Holmstrom and their research visit the following sites:

Nobel Prize - Press Release
The Economist
The New York Times

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