The latest Review of Economic Studies has a great article (ungated here) by Marko Tervio. I'll summarize. CEOs, actors, directors, musicians, authors, and athletes make big bucks because: Desired abilities are rare and lasting.
This theory seems like it's being used overbroadly.
For CEOs, actors, and directors, their salary is really the least relevant cost factor. If you're running a large corporation, or making an expensive movie or television production, given the number of people involved, the risk is the whole project rather than the individual. Hiring an incompetent CEO (might) harm the entire company, causing losses that make his salary look trivial. Same thing goes for hiring a bad director or an actor for a major role. I doubt actors for minor or really minor roles suffer from this effect. For the big shots, their salary is not the determining cost, so "enslaving" them wouldn't change too much.
Authors and musicians carry signifant brand risk. That is, if I publish too many bad books or release too many bad CD's, my brand could suffer, and individuals who have some sense of their abilities (the model requires individual ignorance of talent, which is not wholly realistic) will look for other record labels / publishers. Consumers will be hesitant to purchase my brand. Thus, the main expense is not (necessarily) their salaries. I have some other specific ideas of where this fails, but I am not sufficiently familiar with the industries to voice them with confidence.
Athletes I know relatively little about the structure of. This may have a more significant effect there.
This is still an interesting and useful theory; I'm just not sure that binding contracts are the correct solution.
I refreshed myself on the common pool problem (it's been 25 years since I took an economics course). I think you are suggesting that people aren't motivated by the tournament because the big winner gets parachuted in externally from the common pool. I'm not sure that's true. While it is true, in my experience, that CEO's and other senior executives are often hired from outside the firm; I think most of the people competing in the tournament see that as the "common pool". Or to make it personal, we all know the guys who get parachuted in, and have been those guys as well.
I agree with Robin's general point and with some of what Andrew Gelman is saying as well. I'm not totally satisfied by, "the public wants their heroes unshackled..." we should look more closely at the mechanisms. Here is a closer look at CEO pay:
In many of the disciplines you cite, there is a large random component to performance. The success of a movie is notoriously difficult to predict, athletes have up years and down years, and sometimes businesses do well despite the actions of their CEOs. Longer contracts help to average over such random forces, thus moderating just how desirable a particular candidate is.
Andrew, a bit of influence hardly overturns the basic model here, nor does a substantial random element to productivity; just need product by a person to correlate substantially across trials.
David, rewarding big performers to encourage effort suffers a common pool problem when you usually hire outsiders.
I think CEO compensation has been unhooked from performance for quite some time. It's quite possible to have a company collapse underneath you and still make out like a bandit. I strongly suspect that executive compensation in American companies is more symptomatic of cartels and agent failure than a market for superstars.
I also suspect that the ability to be a reasonably effective CEO is not all that rare. Furthermore, I also suspect that CEO performance (in terms of company stock price) is frequently a matter of dumb luck, much like mutual fund manager performance: past performance is no guarantee of future results.
I think Robin isn't addressing why or under what conditions will you make big bucks. Rather, I see the point of this post as illustrating why it might be worth reconsidering the idea of "enslaving" massively popular artists to ungenerous, long term contracts, despite the unpopularity of this idea.
For him, it comes down to two things, measurement and leverage. If you can show how good you are your job and few others can do it, you'll make big bucks. This isn't a normative claim, just a positive observation.
The voluntary nature of employment is the main thing, and in some cases the only thing, that keeps employee/employer relationships civil. If quitting or being fired carries too high a cost, then employees lose the ability to refuse unreasonable requests. This happens, for example, with H-1B visa workers: if they're ever unemployed they risk being deported, and their employers know this, so they end up with longer hours and worse working conditions than regular employees.
I have a few problems with the arguments. First, athletics is a fundamentally different game, so to speak. It is one of the few places where relative differences between people are so apparent. It doesn't matter if Usain Bolt is only slightly or massively faster than the rest of the field, he'll still be the 100M winner.
The arguments aren't convincing enough, to my mind, to substitute Tervio's model for Lazear's tournament theory. You pay big bucks to the "winners" (CEO's, stars, etc), not because they are worth that much more than a substitute, or that it costs too much to try a new actor, but because it encourages a large field to play.
Robin: My impression is that CEO's have a bit of influence in setting their own salaries even if they do not literally fill in the form themselves. My point about musical and acting popularity is that much of this is unpredictable, in many ways a random event and thus not necessarily assignable to any property of the musician/actor. My colleague Matt Salganik has written about this--the path-dependence or random element about what makes something succeed or fail.
Andrew, individual CEOs do not set their own salaries. It is not technical musical and acting talents that are highly rewarded, it is the ability to make lots of people like you. Bargaining was done in the shadow of the law, and legal decisions were importantly influenced by public (and elite) opinion.
+10 karma, Robin. This is fascinating, concise, and above all useful.
This theory seems like it's being used overbroadly.
For CEOs, actors, and directors, their salary is really the least relevant cost factor. If you're running a large corporation, or making an expensive movie or television production, given the number of people involved, the risk is the whole project rather than the individual. Hiring an incompetent CEO (might) harm the entire company, causing losses that make his salary look trivial. Same thing goes for hiring a bad director or an actor for a major role. I doubt actors for minor or really minor roles suffer from this effect. For the big shots, their salary is not the determining cost, so "enslaving" them wouldn't change too much.
Authors and musicians carry signifant brand risk. That is, if I publish too many bad books or release too many bad CD's, my brand could suffer, and individuals who have some sense of their abilities (the model requires individual ignorance of talent, which is not wholly realistic) will look for other record labels / publishers. Consumers will be hesitant to purchase my brand. Thus, the main expense is not (necessarily) their salaries. I have some other specific ideas of where this fails, but I am not sufficiently familiar with the industries to voice them with confidence.
Athletes I know relatively little about the structure of. This may have a more significant effect there.
This is still an interesting and useful theory; I'm just not sure that binding contracts are the correct solution.
@ MichaelBishop: Fascinating link, thanks.
Robin,
I refreshed myself on the common pool problem (it's been 25 years since I took an economics course). I think you are suggesting that people aren't motivated by the tournament because the big winner gets parachuted in externally from the common pool. I'm not sure that's true. While it is true, in my experience, that CEO's and other senior executives are often hired from outside the firm; I think most of the people competing in the tournament see that as the "common pool". Or to make it personal, we all know the guys who get parachuted in, and have been those guys as well.
"actors, directors, musicians, authors,"
Ahem, Robin, *copyright* *cough*. Monopoly power is OBVIOUSLY going to increase inequality of opportunity! Read Boldrin & Levine.
I dunno how you, being an economist, could miss that.
As for athletes and CEOs, I think you can explain that by the increased cult of fame and increased lobbying for corporate benefits, respectively.
Robin re Tom: more concise than Tervio's article, surely.
I agree with Robin's general point and with some of what Andrew Gelman is saying as well. I'm not totally satisfied by, "the public wants their heroes unshackled..." we should look more closely at the mechanisms. Here is a closer look at CEO pay:
http://www.pay-without-perf...
There might be another benefit.
In many of the disciplines you cite, there is a large random component to performance. The success of a movie is notoriously difficult to predict, athletes have up years and down years, and sometimes businesses do well despite the actions of their CEOs. Longer contracts help to average over such random forces, thus moderating just how desirable a particular candidate is.
Andrew, a bit of influence hardly overturns the basic model here, nor does a substantial random element to productivity; just need product by a person to correlate substantially across trials.
David, rewarding big performers to encourage effort suffers a common pool problem when you usually hire outsiders.
Tom, 9000 words is more concise than 400 words?
I think CEO compensation has been unhooked from performance for quite some time. It's quite possible to have a company collapse underneath you and still make out like a bandit. I strongly suspect that executive compensation in American companies is more symptomatic of cartels and agent failure than a market for superstars.
I also suspect that the ability to be a reasonably effective CEO is not all that rare. Furthermore, I also suspect that CEO performance (in terms of company stock price) is frequently a matter of dumb luck, much like mutual fund manager performance: past performance is no guarantee of future results.
Tom Church,
I think Robin isn't addressing why or under what conditions will you make big bucks. Rather, I see the point of this post as illustrating why it might be worth reconsidering the idea of "enslaving" massively popular artists to ungenerous, long term contracts, despite the unpopularity of this idea.
Paul Graham put it more concisely in this essay: http://www.paulgraham.com/w...
For him, it comes down to two things, measurement and leverage. If you can show how good you are your job and few others can do it, you'll make big bucks. This isn't a normative claim, just a positive observation.
The voluntary nature of employment is the main thing, and in some cases the only thing, that keeps employee/employer relationships civil. If quitting or being fired carries too high a cost, then employees lose the ability to refuse unreasonable requests. This happens, for example, with H-1B visa workers: if they're ever unemployed they risk being deported, and their employers know this, so they end up with longer hours and worse working conditions than regular employees.
I have a few problems with the arguments. First, athletics is a fundamentally different game, so to speak. It is one of the few places where relative differences between people are so apparent. It doesn't matter if Usain Bolt is only slightly or massively faster than the rest of the field, he'll still be the 100M winner.
The arguments aren't convincing enough, to my mind, to substitute Tervio's model for Lazear's tournament theory. You pay big bucks to the "winners" (CEO's, stars, etc), not because they are worth that much more than a substitute, or that it costs too much to try a new actor, but because it encourages a large field to play.
Robin: My impression is that CEO's have a bit of influence in setting their own salaries even if they do not literally fill in the form themselves. My point about musical and acting popularity is that much of this is unpredictable, in many ways a random event and thus not necessarily assignable to any property of the musician/actor. My colleague Matt Salganik has written about this--the path-dependence or random element about what makes something succeed or fail.
Andrew, individual CEOs do not set their own salaries. It is not technical musical and acting talents that are highly rewarded, it is the ability to make lots of people like you. Bargaining was done in the shadow of the law, and legal decisions were importantly influenced by public (and elite) opinion.