God is a Capitalist

Saturday, January 6, 2018

Why executives make the big bucks

Socialists suffer seizures when the subject of CEO salaries surfaces. They never tell us how much more money than a janitor a CEO should make, so it’s clear that no matter what the salary they will harm themselves by their extreme response if it is any higher.

British socialists are advertising their envy in a new report “of companies that Theresa May said risk damaging ‘the social fabric of our country’ by paying bosses too much money,” according to comments by the Adam Smith Institute. The author explained,

"The public register was published on Tuesday by the Investment Association, a trade body of investment firms that manage the pensions of millions of Britons."
The register lists every company in the FTSE All-Share Index which has suffered at least a 20% shareholder rebellion against proposals for executive pay, re-election of directors or other resolution at their shareholder meetings.
Of course, the source of the outrage is pure envy and no amount of economic reasoning or facts will dissuade the left. But can free marketeers justify the highest CEO salaries? There are two reasons that CEOs earn such salaries: 1) marginal revenue and 2) knowledge.

CEO decisions impact their company’s revenues. Good decisions enhance revenues while mistakes shrink them. Let’s assume that the average CEO decision impacts revenues by 10% in order to keep the math easy. So a CEO managing a company with $100,000 in annual sales may affect the revenue by as much as $10,000 per decision, good or bad. But a CEO managing a company with $1 billion in annual sales will change revenues by $100 million. The change in revenue per decision is the marginal revenue effect of CEO decisions. Clearly, companies will want to pay more for the latter CEO in order to get those people with the demonstrated best decision-making skills.

Such reasoning will not matter to socialists at all because in their minds a monkey with two bananas could do as well as any CEO. They have a very low opinion of managerial skills. They often say that CEOs don’t work hard and merely take credit for other peoples’ work. The error in that line of thought is that boards hire CEOs to work. They don’t. They hire them to think, that is, for what they know.

Even socialists can understand American football so I’ll use it as an analogy. What owner hires a coach to throw passes, block and tackle on the field? By socialist standards, NFL coaches don’t work; they merely take credit for the hard work of the players. They must wonder every Sunday and Monday night why owners pays such ridiculous salaries to coaches who do nothing but stand on the sidelines and yell at the referees. Fans will do that for a couple of beers.

Obviously, NFL team owners hire football coaches for what they know about the game, not to play the game. One of the special skills of coaches is recruiting the best players, so he has to know what makes a good athlete. They are also hired for their ability to design offensive plays, defensive strategies, and their knowledge of opponent strategies, strengths and weaknesses.

The same is true for CEOs. Boards hire them for what they know about the industry, finance, economics, people, and many other things. Good CEOs set the strategy then hire the best people they can find to do the actual work. Howard Hughes used to say that he wasn't smart but he knew a smart man when he saw one. Hughes would hire him then get out of his way.

Great NFL coaches are rare and that’s why they make the big bucks. Good CEOs are just as rare.

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