Why exactly is the boss paid so much? Blair Fix says it’s all a question of size.

As the coronavirus pandemic unfolds, we’re seeing a common trend. Companies are firing workers while modestly reducing chief executive officer (CEO) pay. At the same time, we are discovering that the workers who provide our basic services are often among the least paid. This leads to an important question. Do CEOs deserve their pay?

To dive into this question, let’s return to a time before the pandemic. Back in 2016, Steve Easterbrook had a good year. Easterbrook — the CEO of fast food outlet McDonalds — earned about 600 times the average pay of the workers in his company. In the same year, Jonathan Steinberg wasn’t so lucky. Steinberg — CEO of Wisdomtree Investments — earned just eight times the average pay in his company. Why did Easterbrook earn so much more than Steinberg?

Figure 1

The reason, it turns out, is mainly the difference in company size. Easterbrook led a multinational corporation with some 375,000 employees. Steinberg, in contrast, was chief of a firm with about 200 employees. Although it is likely that neither Easterbrook nor Steinberg knew it, each man’s pay was part of a broader trend which is that the relative income of CEOs, it seems, grows with firm size (see figure 1).

Each point in figure 1 represents an American CEO observed between 2006 and 2016. The vertical axis shows the pay of each CEO, as a factor of the average pay in their firm and the horizontal axis shows the number of employees in each firm. You can also see that Easterbrook and Steinberg lie close to the best-fit trend.

This trend raises an interesting possibility. It is likely that Easterbrook and Steinberg had preconceptions that their income stemmed from things like performance, skill or education. And yet knowing none of these things, an unassuming scientist could have predicted Easterbrook’s and Steinberg’s relative income. The scientist would need to know only one thing: the size of each man’s firm.

If you’re surprised that CEO pay grows with firm size, you’re not alone. Few people know about this trend. And yet it’s not a new finding. Economist, David Roberts, discovered it in 1956. In the years that followed, other correlates of income (like education) became well known. But the fact that CEO pay grows with firm size remained obscure. Why?

The answer has to do with the road taken by economics. In the late 1950s (when Roberts published his findings), economists were putting the finishing touches on their theory of income distribution. The roots of this theory dated on the turn of the 20th century. At the time, John Bates Clark had argued that, in a competitive market, people earn what they produce. This idea became known as the “marginal productivity” theory of income.

In its initial form, marginal productivity theory applied only to groups of people (capitalists and workers). It left individual income unexplained. For 50 years, this problem went undressed. Then, in 1958, Jacob Mincer found a solution. He argued that every individual had something called “human capital” — a stock of skills and knowledge. This human capital explained individuals’ productivity, and productivity, in turn, explained income.

Mincer’s ideas spread like wildfire. Soon most economists proclaimed “human capital” a core part of marginal productivity theory. With their newly-minted theory in hand, economists argued that everyone’s income stemmed from productivity.

It was during these heady days that Roberts published his CEO findings. His results, not surprisingly, were mostly ignored. Why? Because they were hard to square with marginal productivity theory. (Roberts himself tried to attribute executive pay to productivity, but his reasoning was torturous.)

While not easily attributable to productivity, the growth of CEO pay with firm size did have a simple explanation. It was the polymath Herbert Simon who first hit upon it. CEO pay increased with firm size, Simon argued, because of hierarchy. Here’s his reasoning.

Firms, Simon proposed, are organised using a hierarchical chain of command. The CEO commands a handful of subordinates. And those subordinates command their own subordinates. This chain of command creates a pyramid structure, with many people at the bottom of the hierarchy and few at the top.

“Income, Simon’s model claimed, didn’t stem from productivity. Instead, it was largely a function of rank.”

On its own, this pyramid says nothing about income. But with one simple assumption, Simon made a startling prediction. If income grows with hierarchical rank, CEO pay will increase with firm size. This is because larger firms have more hierarchical ranks. So the CEO of a large firm has a greater rank — and hence greater income — than the CEO of a small firm. Thus, CEO pay grows with firm size.

Simon published this result in 1957. While the paper had an unassuming name – The Compensation of Executives – it dropped a bomb on economic theory. Income, Simon’s model claimed, didn’t stem from productivity. Instead, it was largely a function of rank. But because Simon was more a mathematician than a social radical, he wrapped his bomb in opaque language.

Here’s how he put it:

“Only an improbable coincidence would bring about equality between salaries determined by the mechanism described here [pay based on hierarchical rank] and salaries determined by the marginal productivity mechanism.”

Translation: this model conflicts with marginal productivity theory.

Was Simon correct? Is income within firms largely a function not of productivity, but of hierarchical rank? Unfortunately, we don’t know.

Although Simon’s paper opened a new road for economic theory, economists chose not to explore it. Instead, they stayed on the trodden path of attributing income to productivity. In the years after Simon’s paper was published, economists rushed to accept human capital theory. The possibility that hierarchy affected income was ignored.

Here’s an example of this blinder. Gregory Mankiw’s textbook Principles of Microeconomics mentions “human capital” 27 times. It mentions “productivity” (and its derivatives) 74 times. Hierarchy is not mentioned once.

Revisiting hierarchy

When I stumbled onto the evidence shown in Figure 1 as a graduate student I set about trying to explain what I thought was a new discovery. So I was surprised when I found Simon’s 1957 paper had documented my finding 25 years before I was born and included the incendiary interpretation that had long been forgotten: income within firms was largely a function of hierarchical rank.

Intrigued by this abandoned road of economic theory, I searched for data on hierarchy. Little existed. In the 60 years since Simon’s paper had been published, few economists had bothered to study hierarchy. After a year of searching, I eventually found a handful of studies that measured hierarchy within firms. While sparse, this case-study evidence suggested that Simon was on the right track.

If Simon’s argument that CEO pay grows with firm size because firms are hierarchically- organised is correct, something similar should hold for all employees within the firm.

“If mainstream theory is correct, Easterbrook earned this windfall because he was superhuman.”

 

As corporate leaders, CEOs command everyone else in the firm. So the size of a firm’s workforce gives (roughly) the number of subordinates below the CEO. So the CEO of a ten- employee firm has nine subordinates while the chief of a 100-employee firm has 99 subordinates.

On that basis we can reinterpret the CEO evidence in Figure 1. It suggests that a CEO’s income grows with the number of subordinates he or she controls. If Simon’s model is correct, the same pattern should hold for all members of the firm.

So does income behave this way? The evidence from case studies suggests that it does (see figure 2).

Figure 2

CEOs: superhumans or despots?

It’s time, I believe, to revisit the road opened by Simon’s model of hierarchy. What’s at stake is the scientific understanding of income and the justification (or lack of it) for mitigating inequality.

To see why our theory of income matters, let’s revisit Easterbrook. If mainstream theory is correct, Easterbrook earned this windfall because he was superhuman. He was 600 times more productive than the average McDonald’s employee. If true, most of us would agree that Easterbrook’s income was fair. So there’s no reason to give part of it to someone else.

Now consider the alternative. What if Easterbrook’s income stemmed not from his productivity, but from his command of subordinates? If true, Easterbrook wasn’t superhuman. He was a despot. Much like the kings of old, Easterbrook used his power to enrich himself. So we have every reason to take part of his fortune and give it to the needy.

As you can see, theory matters. With the unfolding Covid-19 pandemic, it matters even more. If CEO pay stems from hierarchical status (not productivity), then we should not hesitate to redistribute income to those who need it most. Because the stakes are high, it’s worth taking a second look at hierarchy.

References

Fix, B. (2019). Personal income and hierarchical power. Journal of Economic Issues, 53(4), 928–945.

Mincer, J. (1958). Investment in human capital and personal income distribution. The Journal of Political Economy, 66(4), 281–302.

Simon, H. A. (1957). The compensation of executives. Sociometry, 20(1), 32–35.

Roberts, D. R. (1956). A general theory of executive compensation based on statistically tested propositions. The Quarterly Journal of Economics, 70(2), 270–294. seems as good an approach as any.

Blair Fix

Blair is a political economist based in Toronto. He researches how energy use and income inequality relate to social hierarchy. His first book, ‘Rethinking Economic Growth Theory From a Biophysical Perspective‘ …

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