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Saturday, November 11, 2006

Microeconomics quiz of the week

From the WSJ's ProfessorJournal.com:
This week's Capital column reports on a new research paper by economists Xavier Gabaix, Princeton University, and Augustin Landier, New York University, that investigates why real CEO compensation is six times as much as it was in 1980. The reason why CEO pay has increased: the market. The size of firms determines the demand for CEO talent, and over the past 25 years, as measured by stock-market capitalization, companies grew sixfold. Prof. Landier states, "If all companies increase in size, the amount people are willing to pay for the same talent goes up." With larger companies, an improvement in the quality of a CEO has a greater effect on firm profit. The column offers evidence that small differences in CEO quality, for large companies, could lead to large differences in profitability. With an increase in demand for CEO talent and an inelastic supply, CEO salaries have increased.

The column offers a list of alternative explanations of why salaries have increased. "Cozy, corrupt or incompetent board are letting CEOs rip off shareholders. Today's CEOs won't work hard without lucrative incentives. A CEO's job is riskier or harder than it used to be." If Profs. Gabaix and Landier are correct, "then CEO pay hasn't much to do with motivating CEOs to work harder, and there is little economic harm to be done by taxing them more heavily."

The puzzle that remains: the market capitalization of companies rose substantially from the 1940s through the 1970s, yet CEO compensation did not rise much faster than the typical worker's.

The Gabaix and Landier paper can be accessed at:

http://econ-www.mit.edu/faculty/download_pdf.php?id=1293

QUESTIONS:
1.) Explain how a firm's demand for a CEO depends on the size of the firm. Why are larger firms willing to pay more for better CEO talent?

2.) The column states that the supply of CEO talent is inelastic. Explain why this supply is inelastic.

3.) With a perfectly compensation inelastic supply of CEO talent, explain how an increase in the (inverse) demand for CEO talent translates into an increase in equilibrium compensation.

4.) What are the various possible reasons why executive compensation increased from 1980 until 2005?

Reviewed By: James Dearden, Lehigh University

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