Sunday, December 18, 2005

 

The Economics of Executive Compensation - Chuckles Curve Explained

It is time to bring some simple concepts of economics to bear on the matter of executive compensation. To the uninitiated, CEO salaries may seem high. Remember the $188 million package Dick Grasso got last year for running the NYSE? But that’s Wall Street. The CEO of Goldman Sachs just got about $38 million this year. Out in the hustings plenty of CEOs are making do with $10 million or even less. And oh sure, there are critics. Discussing the proposal of the CEO of bankrupt Delphi to set aside $510 million for the top 600 or so executives while cutting workers base compensation from $25 an hour to $10, Ben Stein in today’s NYT said it put him in mind of a scene from an old gangster movie. There “a certain Abe "Kid Twist" Reles - ably portrayed by Peter Falk - is asked why he always wants more when he already has so much. "Don't ask questions," he shouts in response. "What've you got hands for, huh? Take!".

There might be some basis for criticism if these CEOs had anything to do with setting their own booty level, but all that is determined by the compensation committee of the board, and approved by the whole board, in strict reference to the principles of supply and demands. This will require a little economic reasoning, but like we say, this site provides a learning experience. Let’s take the example of a CEO at $14 million. The committee has actually made three determinations: first, that the CEO they can retain at that level is adequate to the task of running the corporation; second, that it would not be profitable to get anyone better by paying more; and third, it would be less profitable to try to get by with what they could get for less, say $12 million. This is a rigorous application of the now generally accepted “Chuckles Curve”.

Full disclosure: I am a graduate economist, and have stayed very close with my circle of economist buddies. In that circle I am affectionately known as “Chuckles”. Economists are a lot more warm and fuzzy than you might think. Anyway, when I invented the executive compensation algorithm it was inevitable that it would become known as the “Chuckles Curve”. This tool is a refinement of the standard supply and demand curves, and proves that the optimum CEO salary occurs when the incremental dollar of salary is exactly equal to the incremental dollar of corporate profit. Think about it. If you could get $2 more profit by paying $1 more salary, wouldn’t you do it? And if $1 more salary is only going to get you $.50, you cut back, right?

The CC has broader application, as seen in the Delphi situation. The $510 million of those executives is just what is needed to keep them from jumping ship. Having run the company into bankruptcy, they know the mistakes, such as paying $25 an hour to people only worth $10, and are best situated to correct them. Undoubtedly with this experience all 600 could find jobs with higher pay in an afternoon. If that was true of the workers, they wouldn’t be worth just $10. Supply and demand, see?

That should put to rest those critics who argue that CEOs really use their power to set their own compensation by putting their buddies on the board, sitting on each other’s boards and donating to each other’s charities and seeing to it that board compensation and perks are “adequate”. Malarky. If that were so, those guys would be no better than a bunch of pirates.

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