Who’s overpaid?

LeBron James Sprite Cans

In our society, people are mostly paid according to supply and demand. If you have a job that a lot of people can and want to do, you generally won’t have a high salary. On the other hand, if you have a high-demand job that few people can do, then you’ll be paid much more. In essence, the market for labor is, in many respects, similar to other markets.

Mostly, this works pretty well. Dentists and doctors should get paid more than low-skilled construction workers. But leaving it there is boring. Instead, it’s fun to look at the areas where this market design fails. And when it comes to salaries, people seem to complain the most about highly-paid sports stars, actors, and musicians.

“He’s paid millions just to play a game!”

It’s obviously true that the ability to put a ball or puck into a net isn’t worth a lot intrinsically. Athletes don’t provide food to millions or greatly improve the standard of living for thousands. You can go for an entire year without watching TV or listening to music, and you won’t die.

Nevertheless, I think athletes, movies stars, and musicians are worth the amounts they are paid. These people are in the business of entertainment, which can be highly lucrative in an economy with the mass media. Today, millions of people can observe a single performance. If you charge $10 for each person, then you have huge amounts of revenue.

What’s more, these sports stars, actors, and musicians aren’t interchangeable. They have their own distinctive abilities and brands. People really want to see LeBron James play basketball or Tom Cruise tear a mask off his face. They don’t want to see me do the same thing, for good reason.

So in an economy with mass media, these celebrities are going to bring in piles of revenue. A significant portion of that revenue wouldn’t exist without the star, so it’s reasonable that they get large paychecks. In fact, I think athletes are often worth more than they’re paid, since the owners of sports teams have collaborated to pay them far less than the natural market wage (using strategies such as capping the amount that a new player or the entire team can be paid).

And if you still believe that these celebrities are making too much, who do you think does deserve the extraordinary revenue these stars bring in? Their sports team? Their recording label? The film studio?

The ones who are overpaid

On the other hand, there is a group that I believe is often overpaid, CEOs of large, successful companies. Much of the time, they’re not providing significant value in excess of what many others could provide in running the company. In many cases, I think you could roughly the same outcome with someone much cheaper.

The crux of the problem is that most large companies are successful because they have competitive advantages. For instance, Pfizer has both patents and trademarks that stop other companies from selling Viagra and the institutional knowledge of how to get drugs through the FDA. Coke has brand recognition and distribution networks. eBay has networking effects (i.e. buyers purchase from the website with the most sellers so they can get the biggest selection at the lowest price).

These businesses have become successful because of these competitive advantages and remain successful because of them. If you’re a retailer, are you more likely to stock a new soda from Coke on your shelves or a new soda from Joe Shlubadub? Clearly Coke. It has the better brand,resources, and organization to launch a new drink.

As the CEO of Coke, you don’t have to be all that smart. It’s quite difficult to mess up badly, because the business has such large competitive advantages. Warren Buffett summarizes the situation for these sorts of businesses nicely: “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”

Nevertheless, the CEOs of these businesses are paid extraordinarily large sums. Often, they’ll get stock or options that will pay them hundreds of millions of dollars even if they underperform the market.

Why does this happen?

This problem arises because the market for CEOs is designed in a way to constantly inflate salaries. It doesn’t obey the “supply/demand” dynamic.

The start of the problem is that for these supersize companies, twenty-five million dollars isn’t that big a deal, often far less than 1% of revenue. So, they have the ability to pay out extraordinary salaries.

Second, the people who determine the salaries are the board members. Typically, board members are also leaders of their own successful companies and friends with the CEO whose compensation package they are deciding.

Thus, as CEOs, they likely often start from the position that CEOs ought to be paid a lot of money because they believe that they themselves should be paid a lot of money. They probably also believe that the CEO is responsible for a huge portion of the success of the company, rather than just being one of hundreds of thousands who could run a business from a strong competitive position. (And really, if Fred’s your friend and the company can afford it, why not pay him lots of money? Fred’s a good guy.)

They’ll generally claim this approach is reasonable because a market research firm agrees with them. A market research firm hired and paid by the highly-paid board, a market research firm that has a choice between saying, “You guys are insane. You’re grossly overpaying your CEO, and are probably overpaid yourselves”, or saying, “Yeah, that’s the right number. You guys are brilliant.” I imagine the market research firm invited back the next year is rarely the one that delivers the former message.

As if this wasn’t enough, many companies have a strategy to pay at the 80th percentile (i.e. pay more than 80% of comparable companies) to their top people. This is justified, of course, by saying that it’s worth making that sort of commitment to ensure that you have the best CEO. But when everyone uses this strategy, it causes huge wage inflation as it’s impossible for more than 20% of companies to be 80th percentile. Price wars develop as 100% of the market struggles to be in the top 20%.

The bottom line

This isn’t to say that all CEOs are overpaid. There are CEOs who, like celebrities, add enough value to their businesses to be worth their huge salaries. But they aren’t the CEOs of Coke or Proctor & Gamble. Rather it’s the guys like Bill Gates, Elon Musk, Mark Zuckerberg, Jeff Bezos, and Warren Buffett–often founders, but not always. These are the people who are able to do extraordinary things that nobody else could do, and in doing so, provide significant value to their businesses.

For me, the key to differentiating them is whether they’re making decisions that a monkey could make or if they’re constantly surprising you in a good way.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s