Executive Compensation and Principal-Agent Issues

Jordan Bell-Masterson

Likely provoked by the rising tide of conversation on inequality, famed Harvard economist Greg Mankiw posted a short article through the NYT defending (presently high) executive pay as fair, making a popular comparison to Robert Downey Jr.’s windfall from The Avengers.  Paul Krugman, Jonathan Chait, and Dean Baker all offered quick rebuttals (credit to Mark Thoma for aggregating much of this thread of debate).       

One of Mankiw’s key lines of argumentation goes like this: executive pay critics often point to principal-agent problems that can occur with a board structure, but closely-held corporations (where board-capture issues are irrelevant) exhibit the same high levels of executive compensation.  A reasonable point, but Mankiw jumps too quickly to his conclusion – that “In light of this, the most natural explanation of high C.E.O. pay is that the value of a good C.E.O. is extraordinarily high,” implying that there are no other meaningful structural problems with executive compensation.     

I think both Mankiw and his various critics overlook a separate, but potentially important market imperfection stemming from an altogether different principal-agent problem: the common-practice use of executive search firms, or headhunters.  Though treated lightly in the literature, the extant evidence suggests that a) these firms are very frequently involved in executive search at the highest levels, and b) their fee is determined as a percentage of the CEO’s pay package.  I bring up point a) to illustrate that this is a widespread issue, which cuts across lines of private, widely-held public, and closely-held corporations.  Where this state of affairs becomes obviously problematic is with b), and it takes little additional thought to see how incentives are misaligned here. 

The company in need of a CEO wants the best performance for the lowest price.  The headhunter, however, only shares one of these motivations – they too want the best performing CEO, so as to gain a positive reputation and receive more work in the future.  But, headhunters’ fee structures incentivize them to go after more expensive candidates, even if the bump in quality is negligible, non-existent, or unable to be accurately assessed either by the client in question or future potential clients (that is, it will not be reputation-undermining to engage in such price-inflating behavior).

There is another healthy debate to be had, another time, about whether headhunters shrink or expand the labor supply (i.e., which effect dominates: the globalization of the executive labor market, or the fact that headhunters’ rolodexes are imperfect in myriad ways?).  At the very least, however, their fee structures create a clear distortion that does not fall to defenses involving closely-held corporations.  Executives may or may not deliver value roughly consistent with pay in 2014, but to imply that the market neatly or perfectly compensates solely hard work and talent is to ignore inconvenient aspects of its structure.  I’m not sure where I come down on executive pay as a whole, but it is puzzling to me that such an apparently glaring misalignment of incentives is so often left out of the debate entirely.

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