April 07, 2008
Compensation under Competition--Posner
It used to be thought more widely than it is now that in a competitive market, the compensation of workers, on the assumption that it is left to the market, will be efficient. That of course is a major assumption, given unions, minimum wage laws, laws against employment discrimination, and other regulations of employment. But such regulations do not bear significantly on the employment of executives and professionals, and it is they with whose compensation I shall be concerned. Shouldn't we expect that they at least--corporate executives, lawyers, and other elite workers--are efficiently compensated, provided their employers are operating in a vigorously competitive market, as most markets nowadays, other than those that are natural monopolies (that is, markets in which economies of scale are obtainable over the entire range of feasible output), but fewer and fewer markets are naturally monopolistic?
The answer should be yes, but increasingly it seems, as a matter both of theory and of evidence, that to implement efficient methods of compensating executives and professionals is extremely difficult, and maybe as a practical matter impossible for a free-market system to accomplish.
There is a long-standing concern that corporate executives are more risk averse than a corporation's shareholders, because the latter can eliminate firm-specific risk by holding a diversified portfolio, while the former cannot, because they have firm-specific human capital that they will lose if the firm tanks. The solution to this problem was thought to consist in making stock options a large part of the executive's compensation, so that his incentives would be closely aligned with those of the shareholders. True, because he would bear more risk, he would have to be paid more in total compensation than if he did not receive a large part of his compensation in the form of stock options. But the cost to the corporation of the additional pay would presumably be offset by the gain to the shareholders from the executives' enhanced incentives to maximize shareholder wealth.
But we are beginning to realize that the grant of stock options may make corporate executives take more risks than the shareholders desire. Suppose that instead of being compensated for bearing risk just by being paid a higher salary or given even more stock options, the executive is guaranteed generous retirement and severance benefits that are unaffected by the price of the corporation’s stock. Now he has a hedge against risk, and can take more risks in operating the corporation because his personal downside risk has been truncated. Perhaps this was a factor in the recent stock market bubbles--the one that burst in 2000 with the crash of the high-tech stocks and the one that burst this year as a result of the collapse of the subprime mortgage market and the resulting credit crunch. A bubble is both a repellent and a lure. It is a lure because during the bubble values are rising steeply, so an investor who exits before the bubble has peaked may be leaving a good deal of money on the table. He will be especially loath to do that if he is hedged against the consequences of the bubble's eventual bursting.
Boards of directors could devise compensation schemes that limited the attractiveness of risky undertakings, but they have little incentive to do so. The boards tend to be dominated by CEOs and other high corporate executives of other firms, who have an interest in keeping executive compensation high and who are abetted by compensation consultants who naturally recommend generous compensation packages to directors who are recipients of generous compensation and therefore believe that the CEOs of the companies on whose boards they sit should be paid top dollar.
It is not clear what the free-market antidote to this tendency to ratchet up executive compensation is. The compensation of the CEO and other high officials of a large corporation is usually only a small part of the corporation's costs, so shaving such compensation is unlikely to be a powerful competitive weapon. But more important, what rival corporation would have the governance structure that would enable such shaving to be accomplished by overcoming the obstacles that I have discussed? The private-equity firm is a partial answer, because it has only a few shareholders and so need not delegate compensation to a board of directors that has other interests besides the welfare of the shareholders at heart. The reason it is only a partial answer is that there are too few owners of capital who want or have the ability or experience to participate as actively in management as the private-equity entrepreneurs and there are too many efficiently large corporations for all of them to have the good fortune of being owned by a handful of entrepreneurial investors. There is a vast pool of passive equity capital that can be put to work only in companies that are organized in the traditional board-governed corporate form.
Here is another though related example of a stubborn efficiency-in-compensation problem, also in a highly competitive sector of the economy: law-firm billing practices. Major law firms, with few exceptions, base their bills to their clients on the number of hours that the firm's lawyers work on the client's case or other project. In other words, they bill on the basis of inputs rather than outputs. This is rational when output is difficult to evaluate, as is often the case with a law firm's output because of the uncertainty of litigation (in nonlitigation practice, because of legal and factual uncertainties). The fact that a firm loses a case doesn't mean that it did a bad job; both the winner's firm and the loser's firm may have done equally good jobs--the lawyers don't control the outcome. A law firm can give the client a pretty good idea of the quality of the lawyers it assigns to the client's case, because there are observable proxies for a lawyer's unobservable quality, proxies such as his educational and employment history. What the client cannot readily judge is whether the law firm put in excessive hours on the case, and the result, according to persistent and cumulatively persuasive anecdotage, is a tendency for law firms to invest hours in a case beyond the point at which the marginal value of the additional hour is just equal to the marginal cost to the client. Young lawyers often feel that they are being assigned work to do that has little value to the client but that will increase the firm's income because the firm bills its lawyers' time at a considerably higher rate than the cost of that time to the firm. The very high turnover at many law firms is attributed in part to dissatisfaction of young lawyers with the amount of busywork that they are assigned, work that bores them and does not contribute to the development of their professional skills, yet may be very time-consuming.
The problem is compounded by the distorted incentives of corporate general counsels. A general counsel wants to show his boss, the corporate CEO, that he monitors expenses carefully, and, since he knows that he is likely to lose at least some of his cases, he also wants to be able to avoid if possible being blamed by his boss for the loss. Hourly billing serves both of these ends. The law firm and the general counsel play a little game, in which the law firm prices its hours on the assumption that it will not be able to collect its billing rates on all of them, and the general counsel reduces the number of hours that he is willing to pay for. He can then show his CEO that he squeezed the water out of the law firm's bills. At the same time, by paying a prominent law firm by the hour, he can assure his CEO, in the event a case is lost, that he had told the firm to do as much work as was needed to maximize the likelihood of a favorable outcome, rather than paying a fixed rate agreed to at the outset that might have induced the law firm to skimp on the amount of work it put into the case.
One can imagine a law firm's adopting a different method of pricing, in which it would charge at the outset a fixed fee, subject to adjustments up or down at the end of the case based on outcome, amount of work, or some other performance measure or combination of such measures. The conventional law firm billing system is a form of cost-plus pricing, which is considered wasteful. But litigation is risky, and cost-plus pricing diminishes risk by eliminating a contractor's incentive to cut corners. If the disutility of risk to a general counsel is great, he will prefer to "overpay" law firms rather than trying to explain to the CEO that the novel compensation deal that he worked out with the law firm that lost the case was not a factor in the loss; that he had not been penny wise and pound foolish.
Although the compensation practices that I have described seem inefficient, it does not follow that corrective measures would be appropriate. They would be costly and the net benefits might well be negative. It is efficient to live with a good deal of inefficiency. Stated otherwise, the fact that competitive markets contain large pockets of inefficiency is not in itself inefficient. For example, while cartel pricing is inefficient, if the cost of preventing cartelization exceeded the benefits one wouldn't want to prevent it. Yet cartel pricing would still be inefficient in the sense of misallocating resources, relative to the allocation under competition. We must live with a good deal of inefficiency, but it is still inefficiency.
Posted by Richard Posner at 09:22 PM | Comments (13) | TrackBack (0)
Trackback Pings
TrackBack URL for this entry:
http://www.lessig.org/cgi-bin/mt/mt-tb.cgi/1682
Comments
Geez! This is quite a different tune played on a different harmonica than that of "Medicare inefficiency".
Posted by Jack at April 7, 2008 10:32 PM | direct link
It is a different tune. Probably because paying millions of dollars to a handful of CEOs, if inefficient, isn't nearly as inefficient as paying the healthcare bills of millions of elderly Americans.
Posted by John at April 8, 2008 01:18 AM | direct link
If the billable hour were such an inefficient method of compensation, one would expect to see firms start to devise other compensation methods for routine litigation matters such as employment litigation. There, the GC really could tell the boss that he is trying to cut costs without worrying for being blamed if the company loses. I haven't seen much evidence that this has occurred, though, which makes me think that the billable hour may be more efficient than you think.
Posted by Jeff V. at April 8, 2008 07:30 AM | direct link
I'll only comment on lawyer comp. Great private-sector lawyering still happens every day in America at a "set" fee. It happens in our criminal-law and sometimes family-law courts. The fee is "set" because - win, lose or draw - it's usually the only compensation the lawyer's going to see. And it's usually collected at the time of hire. "Inefficient" is too charitable a term for the wasteful multiplication & protraction of lawyer comp that's tolerated if not accepted on the civil side.
Posted by Brian Davis at April 8, 2008 09:25 AM | direct link
Judge Posner,
Suddenly I realize that you are a philosophical conservative. Changing an imperfect system might get you something even less desirable. Could you talk to Hillary and Barack for us?
Posted by Jim at April 8, 2008 10:21 AM | direct link
One of the big problems with implementing set-fee lawyering in big cases is that it's extremely tough at the outset of a case to predict how much lawyer time the case will take.
It makes a huge difference whether the case is dismissed or settled at the 12(b)(6) stage, or whether it proceeds to discovery. Often, that just can't be predicted. It also makes a huge difference whether the case is resolved at summary judgment or proceeds to trial.
Frequently, sophisticated corporate clients may be in a better position to estimate costs than the outside lawyers. A lawyer might think the case looks easy based on the client's description -- but then discovery reveals a smoking gun in the client's files that prevents summary judgment.
You could figure that it will all average out among repeat players -- that the corporation will pay a per-case flat fee that roughly matches the average dollar value of the run of its cases, and that the law firms will think likewise in their billing. But that certainly doesnt work for big cases (think of the Microsoft antitrust suit) that can represent a huge share of a law firm's work or the corporation's legal budget during the time in question. And there's a great human tendency to resent the overpayments (or the undercharging, if you're the law firm) in any individual case. (Think of what the anti-plaintiffs groups say about the lawyer who takes her 30% cut of the accident victim's quick settlement -- they're outraged at someone getting paid so much money for the small amount of work done in the individual case; they don't consider it balanced out by the vast number of unsuccessful cases the lawyer also takes and works hard on.)
Posted by dcuser at April 8, 2008 12:37 PM | direct link
Judge Posner points to a problem that is becoming more and more generalised. The economies of the world are featuring human capital more and more prominently in their production functions. Human capital is less homogeneous than physical capital; and the contribution of human capital to a desired outcome is often intrinsically more uncertain.
However the patterns and difficulties in rewarding both forms of capital appropriately are analagous. Where there is a fair degree of homogeneity it makes as much sense to pay an hourly market rate to an engineer as it makes to pay the market rate for the work station he sits at. If the supplier of work stations persuades you to to pay for a model with twice the capacity you need because you are not able to judge what capacity is required, he is doing no more and no less than the firm of attorneys who persuades you to pay for their juniors who have nothing to do. You may expect to suffer as any firm will that loses control of its inputs.
But what it is worth paying for access to IBM's Blue Gene computor, for hiring an excellent lawyer, a top-flight geologist, a really good manger or any other piece of clearly non-homogeneous capital really is a gamble. The place to look for a pattern of billing which will encourage both good buying and effective supply is probably the theory of repeated games. For eaxample, I would reason from that theory that a pattern of billing that charges per professional hour a rate that just keeps the lawyers in business, combined with a substantial margin dependant on the levels of client satisfaction achieved, is likely to achieve a better long term result for both the law firm and the client company in Judge Posner's example; and it would probably tend to enhance the general counsel's status in the corporation.
Posted by David Heigham at April 8, 2008 12:41 PM | direct link
I find a problem with assuming that since (experience has borne out) the billable hours model is as efficient as it is going to get, the same must be true regarding inefficiency in executive compensation models. Maybe the inclusion of the example of billable hours is just that, an example; but it reads as if it is supposed to be evidence toward the inefficient solution conclusion, not just an incedental example.
Second, apparently a conclusion is reached that an inefficient solution for executive compensation is the best solution--without even discussing or leaving the door open for potential alternatives (with the minor exception of mentioning private-equity firms).
(((btw, i commend the use of a hyphen in "private-equity")))
Posted by Ben F at April 8, 2008 12:52 PM | direct link
CEOs receive over 360 times the average workforce salary. If we replaced each CEO with 100 qualified people, each earning $150,000, would not a company, shareholders, and economy be more productive, creative, and profitable?
Yet it is possible that even without CEOs companies would still exist. That is, large corporations usually don't succeed or fail based on one person, but one person can also make a significant difference. In fact, many investors bet on the jockey and not the horse, so to speak, and winners find a way to win. So, how do companies value or decide who is a winner and what that person is worth? Is the formula based largely on track record, pedigree, friendship, and connections?
Whatever the formula, companies don't always hire winners. Even executives with poor track records are hired and some continue to make bad decisions and lead companies to bankruptcy. For example, Morrison Knudsen, Enron, Worldcom, Merrill Lynch, Citibank, Countrywide, Bear Stearns (and the list goes on), all had well compensated CEOs who destroyed their companies while collecting inflated paychecks and still the companies continued to reward the CEOs, even with golden parachutes.
Over-inflated CEO salaries would be more acceptable if CEOs were also punished for poor performance. It is frustrating to the shareholders, workers and public in general when someone like Merrill Lynch’s former CEO, Stan O’Neal, received over $160 million when Merrill Lynch reported its largest ever quarterly loss of over of $2 billion and a total loss of over $8 billion for 2007 (New York Daily News).
According to CNN, Citigroup's former CEO, Charles Prince, received over a $10 million bonus for 2007, and was allowed to keep $28 million in stock because he resigned rather than be fired. Why did Charles Prince receive millions in bonuses when his company lost billions? On a smaller scale, if a mailroom employee had lost comparatively much less, say several thousand dollars because of bad decisions, he would be fired without recourse let alone a golden parachute.
According to USA Today, Countywide's CEO, Anthony Mozilo, earned $120 million despite losses of $1.2 billion in 2007. Of what value is Mozilo's pay when his company lost so greatly? Mozilo should be required to pay back the wages “earned” to help cover the losses of his company!
Over the past five years Bear Stearns’ executives have received millions in compensation and were some of the most highly compensated investment banking executives on Wall Street. Why aren't Bear Stearns’ executives required to pay back some of their earnings from the past five years to help cover their losses?
Even more alarming, if you look at private equity and hedge fund managers compensation in 2006, each of the top 20 managers earned an average of over $650 million, i.e. more than 15,000 times the earnings of the average worker and over 40 times average earnings of CEOs.
The highest paid hedge fund manager earned $1.7 billion in 2006. Is a hedge fund manager worth $1.7 billion? This is gratuitously excessive, yet hedge fund managers’ earnings are taxed at the long-term capital gains rate of 15% instead of the (higher) income tax rate, which is the tax rate of regular workers.
According to Business Week surveys, which take a regular look at the nation's largest public companies, in 1980 the average CEO made over 40 times the average workers’ wage. If the average workers’ wage had grown over the past 20 years at CEO pace the average worker would be earning well over $100,000 instead of $41,000. Did the value of the CEO increase and the value of the employee decrease? Has immigration both legal and illegal caused the huge earnings gap between CEOs and their employees? Are the CEO salaries a function of the growth of the company’s stock, the stock market, productivity, creativity, innovation, vision, etc?
When companies do well the boards praise and reward the CEOs with enormous compensation packages for jobs well done, yet when companies do NOT do well the boards still reward the CEOs with enormous compensation packages. The absurd paradigm is frustrating to the workers and common taxpayers who are shouldered with the burden.
CEOs’ salaries are similar to or at the level of celebrity salaries, yet the public is not outraged at celebrity salaries. The public is more accepting of the enormous earnings of athletes, artists, musicians, actors, authors, because if these people don’t perform well, their earnings go down. Unlike CEOs, these people are responsible for their own success or failure and compensated accordingly.
If we changed our tax code so companies were allowed to deduct up to $100,000, annually, per individual, companies could pay a CEO or any employee whatever they wanted. This would apply to sports teams/organizations, partnerships, LLC's, hedge funds, law firms, PTPs, ad firms, movie studios, everyone. With this change to the tax code, enormous compensation packages would no longer be on the backs of the taxpayers.
By limiting the tax deduction to $100,000 per employee, companies would have to evaluate if multi-million dollar pay packages were prudent, since companies would not be able to reduce their profits and thus tax liability through million dollar salaries. Boards would have to decide whether CEOs were truly worth millions in compensation that could not be deducted.
Under this plan, the government is not telling companies what they can pay a CEO; the government is merely limiting the deduction. Companies would decide if they want to absorb the cost of the CEO compensation or use the money for other purposes.
Limiting the tax deduction to $100,000 (including stock options and more) per individual, allows companies, not the taxpayers, to feel the full impact of the boards/stockholders decisions.
Only the board of directors should decide what is fair compensation, but whatever the board decides should not be on the shoulders of taxpayers. The public has had enough of this burden.
Posted by Elle at April 8, 2008 11:21 PM | direct link
Elle: Excellent analysis of the socialism for the rich that is destroying our nation. The real heroes of business are the "CEO's" of America's millions of small businesses who most often operate with inadequate capital and for whom the downside is complete ruin and personal bankruptcy.
I like your idea of limited deductibility as it seems the concept of deductible business expenses were meant to apply to costs of goods sold and legitimate mfg and distribution costs so that only profits were to be taxed. The other reason for a deduction would bt that of a societal good such as spurring more research or providing affordable housing. Exorbitant salaries seem neither of these.
But, given the run-up of the last 25 years and an interlocking directorate of an old boy's club would even respond to the additional tax bill or take it too out of the hides of those of average or median wages.
One thing is sure that some form of flattening is necessary so that those who've been squeezed the hardest can re-enter the market place and mop up some of the world's over-capacity by fulfilling at least a few of their long, unmet needs; even billionaires can only use so many goods and services.
But, Ha! perhaps, if, as more than a few suggest, it's 1928 again, it flattens itself and Barack? becomes by necessity the FDR of another New Deal?
Posted by Jack at April 9, 2008 01:25 AM | direct link
Hallo nice to see your blog here
I am so happy to make a friend with you
Posted by MIEK GAO at April 9, 2008 04:08 AM | direct link
Dear Becker and Posner:
I recently heard about the case of Alton Logan, a wrongfully convicted murderer in the state of Illinois. Even though two public defenders knew that one of their own clients was responsible for the killing, they did not speak out to prevent the wrongful conviction. Lawyer-client privilege was the argument. The economics of it is simple: if the lawyer-client privilege is not in place, the whole system will break down. In other words, suspected criminals will not seek legal counsel and furthermore, will not reveal any thing that will incriminate themselves. In theory and on paper, it is logical, but does it make practical sense in real life where one's life is at stake? Lastly, codes of ethnics are only bare minimums.
Posted by Jie at April 13, 2008 10:31 AM | direct link
"It is efficient to live with a good deal of inefficiency."
To wit, Warren Buffett has made a lot of money of those inefficiencies over the years:
"I mean, you don't want a capital market that functions perfectly if you're in my business. People continue to do foolish things no matter what the regulation is, and they always will. There are significant limits to what regulation can accomplish."
http://money.cnn.com/2008/04/11/news/newsmakers/varchaver_buffett.fortune/index.htm?source=yahoo_quote
Posted by Michael Martin at April 14, 2008 11:40 AM | direct link
