Power,Luck and Ideology – Technological and Institutional Parameters of the Agency Problem for CEOs *

Abstract

We propose an explanation for the growth of executive pay since the 1980s. New information and communication technologies (ICTs) appear to favor winner-take-all markets and to accentuate firm-level volatility of profits. We show, using an efficiency wage model, that these changes lead to higher executive pay. This is an example of what we have called, in other contexts, power-biased technological change (PBTC). The changes in market structure and the power of CEOs, however, are not only technologically but also institutionally contingent.

JEL Classification: D31, J41, O33

Keywords

information technology power-biased technical change inequality CEO compensation efficiency wage winner-take-all

1. Introduction

The decades-long upward spiral of the income share of the top 0.1 percent of Americans has been concentrated in earned income – salaries and entrepreneurial income – not least, that of corporate executives (Piketty and Saez 2003). The rise in earned income inequality is often attributed to a greater winner-take-all (WTA) character of markets (Frank and Cook 1995; Levy and Temin 2007). If we accept this explanation, we are still left with significant questions. Is the WTA market structure the product of new technology, or of institutional change? Is the connection between WTA and executive pay via a market for scarce skills or abilities, or should it be understood as an agency problem?

We argue that both technological and institutional change jointly contribute to the creation of WTA markets: WTA markets result from privately appropriable increasing returns; increasing returns have a technological basis, but the private appropriability of those returns is institutionally contingent. The revolution in information and communication technologies (ICTs) has made new corporate structures and new market structures possible; post-1980 neoliberal regimes represent a political choice to scrap mid-century regulation rather than adapt it to the new technologies, and this choice has fostered new WTA markets growth. We argue, further, that agency, not skill or ability, is the principal mechanism connecting WTA markets with high pay: WTA markets generate firm-level volatility which exacerbates the information asymmetry between shareholders and executives.

A large literature connects changes in technology with changes in the distribution of income. Most of this literature is based on the skill-biased technological change (SBTC) hypothesis, which assumes that technology affects distribution through the demand for skill - including the skills of CEOs (e.g. Murphy and Zábojník 2004; Gabaix and Landier 2008). Changes in the demand for skill, however, may be less important than technology’s contribution to changes in workplace power relationships, what we call power-biased technological change (PBTC): modern ICTs have reduced individual worker’s power by improving monitoring (Skott and Guy 2007; Guy and Skott 2008).¹ This paper presents a mirror image of our earlier work, with PBTC now applied to executives: the ICT revolution has enhanced their power and pay.

The SBTC literature typically ignores any role of institutional change. It is suggested – sometimes implicitly – that the simultaneous increase in both relative employment and relative pay of particular groups of workers can only be explained by SBTC. We reject this claim (Skott and Guy 2007; Slonimczyk and Skott 2012).

Another literature treats changes in distribution as a product of institutional change (DiNardo et al. 1996; Atkinson 2000), often coupled with critiques of the SBTC hypothesis (Card and DiNardo 2002; Howell 2002; Mishel et al. 2013). This literature typically ignores any possible interdependence between technological and institutional change. We argue, by contrast, that technological and institutional changes can be closely linked.

Section 2 describes important changes in technology and their effects on market structure and the agency problem. Section 3 considers interactions between technological and institutional factors. Section 4 summarizes the results from a formal model of CEO pay. Section 5 concludes.

2. New Technology, Winner-take-all, and Volatility

Market structure is different today than it was in the mid-twentieth century. Then, stable oligopoly was the rule in sectors dominated by large corporations; today, many such markets are WTA. Then, aggregate volatility dominated; in recent decades, even when aggregate volatility has been low, the volatility of outcomes for the individual firm has been high. (Where is Blackberry? Where will Nokia be tomorrow?) WTA means that greater consequences ride on the choices made by CEOs; firm-specific volatility exacerbates the information asymmetry between executives and shareholders. Thus, both WTA and volatility change the parameters of the agency problem. The result is a rise in the power and pay of top executives. We argue that all these changes result from the application of new ICTs in a deregulated, neoliberal environment.

2.1 Codification

Use of ICTs involves codification, which can be understood as the process of turning knowledge into information or, in other terms, making tacit knowledge explicit: it puts some knowledge in a standard form (a code), which makes it easier to communicate, to re-use, or to share knowledge. Codification has long been important in the advance of the organization of production; consider the standardization of production methods and the creation of interchangeable parts, the ability to incorporate such instructions in computer programs, or the ability to manipulate the genetic code.

Codification is often a source of increasing returns; codification is costly, and results in a set of instructions which reduce the marginal cost of production. In the case of what we can call pure information products, the marginal cost of production at any scale is trivial in comparison to average cost: for example, digitized music, film, and games; general purpose software, such as Microsoft’s Office and Windows; and genetically modified organisms. Beyond these extreme cases, the costs of designing products and processes have risen while the marginal costs of production have fallen for many goods and services.

When the replicable code and/or the technical standard are proprietary, they create private increasing returns and winner-take-all markets. This tendency can be reinforced by network effects.

2.2 Modularity: outsourcing, offshoring, and corporate parts

ICTs (along with transport technologies, such as container freight and air travel) facilitate the geographical dispersal of production. Technological advances have made it possible to do outsourcing on a modular basis, with technological and contractual details sufficiently well codified that business in a highly interdependent supply chain can be conducted at arm’s length (Sturgeon 2002).

Modularity makes it possible to isolate sources of rents – in the language of business strategy, sources of “sustainable competitive advantage” or “core competencies” of the organization – limiting the pool of people who are able to exercise some claim on a share. Earnings differentials within organizations are lower than what we would expect for the same individuals in the market (Frank 1985). Thus, modularity directly helps explain the particularly steep rise in between-firm wage inequality (Juhn et al. 1993).

More importantly, from the perspective of executive pay, modularity fuels the market for corporate control by creating smaller and more internally homogenous corporate elements for which there is a readier market, a sort of market in company parts.

2.3 WTA, technological change, and volatility

During the “great moderation” of the late 1980s and 1990s, many aggregate measures saw reduced volatility, while at the firm-level volatility of both financial and productivity measures grew. Growing firm-level volatility has been tied, empirically, to new technology, either through uneven experiences with the adoption of technology (Chun et al. 2010), or uncertainty in the firm’s market for its own technology (Comin et al. 2009). The latter is consistent with WTA markets, and also with the common observation that product life cycles have become shorter (von Braun 1990).

For our purposes, the important point is that firm-specific volatility presents a problem of information asymmetry. Executives may have private information as to whether a bad performance by the firm was unavoidable, or the result of poor executive judgment or effort. But as volatility grows, owners face an increasing risk of dismissing executives for bad performance when the bad performance was outside their control or, conversely, retaining poor executives when good performance came as a result of pure luck.

3. Technological and Institutional Determinants of Executive Pay

Thus far, our story has been technological: new ICTs change market structure. Yet WTA markets and much of the associated firm-level volatility exist not only because of technology, but because institutional arrangements allow them to exist. Consider four examples: network effects, monopoly due to intellectual property rights, modularity, and the market for corporate control.

3.1 Network effects

Many markets created by new ICTs have WTA properties because of network effects, as seen in Facebook’s and Twitter’s domination of their respective markets, or Microsoft’s domination of personal computer operating systems and standard productivity applications. This has a technological face, but also a regulatory one: Microsoft’s position has been hard fought with courts and regulators in many countries for many years, and rests not on the substance of its products, but on the slender reed of being allowed to control certain application program interfaces (APIs), such as document formats. In a regulatory regime where such interfaces are public property, software markets would have very low entry barriers and could function largely as markets for customization and service (Stallman 1985).

The institutional contingency of technologically facilitated network monopolies is also apparent in one that has not happened: despite persistent lobbying by internet service providers (ISPs) for the right to prioritize content as they choose, in the case of the Internet (unlike, say, the case of cable TV, which often goes down the same wires) “net neutrality” has been largely maintained in the United States. This represents the continuation, and adaptation to a new technology, of the common carrier principle, a legacy of earlier generations of network regulation.

3.2 Intellectual property rights

Even absent network effects, WTA markets can be created by the structure of intellectual property rights (IPRs). In recent decades, IPRs have been extended through legislation, court decisions, and treaties (Sell and May 2001): new categories have become patentable (genetic code, software); broader patent claims are allowed, making it harder for competitors to “invent around” a patent (Freeman 1995); pharmaceutical companies are permitted to leverage their patent rights with a variety of legal protections both from international trade and from sensible public procurement; the copyright doctrine of fair use is undermined by the rental model for digital media; internationally, the TRIPS treaty makes intellectual property protections more uniform and enforceable; IPR rights are commonly extended beyond the TRIPs provisions by bilateral agreements between the United States or EU and their smaller trading partners. Thus, although codified information makes up more of what we buy than it once did, it would be incorrect to say that this technological fact creates, or necessitates, the expansion of IPR monopolies (Boldrin and Levine 2008).

3.3 Modularity

The ability to exploit modularity creates consequential choices for the executive, involving private information and uncertain outcomes. Yet, again, there are a number of ways in which a different institutional environment might constrain these choices: they are fueled by trade policy (not only the reduction of trade barriers, but a range of tax subsidies to investment in new jurisdictions and locations), by a capital market highly tolerant of leverage, and in particular by weak protections for employment, wage rates, pension rights, and union representation, all of which make it easier to exploit modularity for purposes of cost reduction.

3.4 Financialization

The fact that financial deregulation is associated with dramatically higher salaries in the financial sector is well documented (Philippon and Reshef 2008). The rise of pay on Wall Street is linked with the simultaneous rise in pay of CEOs by more than coincident instances of regulatory dereliction. Financial deregulation was part of what is often called the financialization of the economy, which has two salient characteristics. One is a high tolerance for risk, on the part both of regulators and investors, in a way consistent with the Minsky-Kindleberger model. The other is the elevation of shareholder value to its place as the overriding and central responsibility of corporate directors. The latter gained support from the movement of pension funds into securities markets (O’Sullivan 2001), which created a mass political constituency for the principle of maximizing shareholder value.² High leverage and the principle of shareholder value gave bankers and executives the means and the motive for creating an active market for corporate control, which includes, as noted in our discussion of modularity, a market for corporate parts. While this market has in the past been praised as offering a solution to the principal-agent problem (Jensen 1989), we want to emphasize something else: it offers, to both executives and their Wall Street counterparts, an unending stream of consequential decisions taken under conditions of asymmetric information and uncertainty.

3.5 Technology, contingency, and institutional change

One can accept that the effect of technologies on agency problems is institutionally contingent and still hold that technology (or what Marx called the forces of production) is crucial. A given technological endowment may render certain institutional equilibria unstable (or, in Marx’s language, utopian). To clarify this point it is useful to consider the role of earlier generations of technology in the period sometimes called the “Great Compression.” Between 1942 and 1980, dispersion of wages and the income shares of the top 1 or 0.1 percent both were low compared with the periods before and since.

Institutional change is the obvious proximate explanation of the compression. The list of institutions strengthened (or originated) at the dawn of the Great Compression is pretty much the same as those that neoliberalism from ca. 1980 weakened (or abolished): protection of collective bargaining rights and, as a consequence, powerful unions; progressive taxation; regulation of banking and financial markets; price or rate of return regulation of network industries; the common carrier principle in transport and communications; unemployment insurance; the minimum wage. Together with Keynesian fiscal and monetary policy, such measures constituted the regulatory framework of the Great Compression.

We can see the regulatory system of the Great Compression in the same way as the missing regulatory regime of our own time, a means of pulling in the tails of whatever income distribution would have been created by unregulated markets and unconstrained monopoly. In this case, the technologies are those associated with mass production; in recognition both of Ford’s five dollar day and of the emblematic consumer good of the period, this is often known as Fordism (Marglin and Schor 1990; Aglietta 2001), a deal sealed at the “treaty of Detroit” (Levy and Temin 2007).

In earlier work we have argued that the technologies of the Fordist era were essential to unionization and, in turn, that unionization was essential both to redistribution at the level of the firm or industry and to the political coalition that backed the larger institutional package of the Great Compression (Guy and Skott 2008). The technologies in question are, again, ICTs, in this case the likes of the telegraph, the telephone, and the tabulating machine. Such technologies made it feasible to coordinate an elaborate, planned division of labor involving hundreds of thousands of employees in big corporations. The rigid bureaucratic structures for which the mid-twentieth century was known were a reflection of both the capabilities and the limitations of the ICTs of the day. Economies of scale, scope, and speed offered substantial productivity benefits to large managerial firms; realization of these productivity gains was contingent on solving problems of coordination and control, and the limitations of the information systems necessitated a relatively rigid, single-path flow of materials and information. As a result, in 1937 workers at General Motors were able to bring a large part of the operations of the company and many of its suppliers to a halt by sitting down in a few factories. Similarly, with telephone networks, the limited number of paths empowered operators – who instead of sitting down went on strike by standing up – at the same time, across the country.

The same organizational rigidity that empowered groups of workers reduced executives’ scope for action, and limited their agency rents. Moreover, by providing a setting for industrial conflict which sometimes threatened profitability, rigid organizations gave labor unions and government regulation a role in promoting orderly industrial relations. Thus, the limitations of ICT facilitated the institutional changes that contributed to the Great Compression

This technological explanation for the onset of the Great Compression could help make sense of the fact that something similar seems to have occurred at about the same time in many different countries: within antagonists on both sides of World War II (the United States, UK, France, Japan) and in neutral countries both fascist and social democratic (Spain, Sweden) (Piketty and Saez 2007). Yet, these collapses in the income share of the top 1 percent are so close together in time that it is not really plausible to see them as independent national responses to technological changes; even if such responses were entirely mechanistic (which surely, they are not), the countries in question were at different levels of development. Whatever assistance there may have been from the technological quarter, we must also be looking at some sort of policy contagion. And of course it is easy, in hindsight, to identify characteristics of an era’s production organization that seem to have driven the institutional changes that followed.

The limits of technological determinism are illustrated by the diversity of international experience today. Increases in inequality and executive pay are widespread, but vary considerably in magnitude. Looking ahead, it is hard to say whether a grand Polanyist social response like that which produced the Great Compression is possible with today’s technological endowment and existing American institutions; eighty years ago, at the start of 1933, it was not clear that the regulatory framework of the Great Compression was feasible, either.

4. A Model of Executive Pay

The activities of top executives differ from the tasks of most production workers in at least two ways:

– the indivisibility of the discrete managerial decision and the uncertainty surrounding the effects of the decision (and the counterfactual)

– the skills required to perform the task.

A skill based approach highlights the second element, suggesting that new technology has raised the marginal product of the high-skill managerial input. But as suggested by the first element, unpredictable forces play an important part in determining success. Moreover, the fact that skill is involved does not prove that executives are uniquely skillful or even that it is the skill that is being rewarded.³ The agency problem suggests that high compensation may persist even if owners can choose from a pool of potential managers, all with exactly the same skills; high pay may depend more on non-skill elements. In fact, our formalization of the agency problem shows that an increased sensitivity of profits to managerial input can lead to a reduction in pay.

Our formalization – see Skott and Guy (2013) for details – assumes that the firm’s profits before managerial pay can be written as the sum of two terms,

Π = f (e; μ, A) + λε

We focus on CEO pay and assume a single manager. The first term in f relates profits to the CEO’s “effort” (e). As in efficiency wage models generally, effort should be seen as a shorthand for acting diligently and in the best interest of the principal. Thus, effort includes not just putting in the effort that allows sensible decisions to be made but also making the “right” decisions, given the evidence, as opposed to skewing decisions in ways that favor managers at the expense of owners, whether by wasteful expenditures on corporate jets or the manipulation of indicators that determine managerial remuneration. The parameters μ and A determine the shape and position of the f -function: an increase in μ raises the sensitivity of profits to managerial effort; an increase in A produces an upward shift in the profit function. The second term is a random shock; ε is a stochastic variable with mean zero and variance σ²; an increase in the parameter λcorresponds to a more risky environment.

New ICT and associated regulatory and institutional changes have affected the parameters A, μ, λ: options to outsource, for instance, and the effects of this option on domestic wages have provided new sources of cheap labor and raised profits for any given managerial effort; the emergence of a range of new options have increased the sensitivity of the outcome to effort; a less stable and more uncertain business environment have increased both the sensitivity of profits to effort and the variance of the firm-specific random component.

Using a modified Shapiro-Stiglitz model – a CEO either provides low effort (shirks) or high effort – different cases arise; the interesting case is one in which (i) the firm will want to ensure high effort – this happens as long as profits are sufficiently sensitive to CEO effort – and (ii) the overlap between outcomes associated with high and low effort is non-empty. With these assumptions the model implies that:

an increase in A has no effect on CEO pay.

an increase in μ reduces CEO compensation and raises profits. The reason is simple. A higher sensitivity makes it easier to determine whether the CEO is shirking; the agency problem is alleviated.

an increase in λ raises CEO compensation and reduces profits.

a proportional increase in μ and λ leaves CEO compensation unchanged and enhances profits net of CEO compensation.

Efficiency-wage arguments can be cast in different ways. The Shapiro-Stiglitz formulation is standard in the literature and it also seems to fit traditional Marxian notions of labor discipline. Formulations that emphasize fairness and reciprocity, however, may have more empirical support than the Shapiro-Stiglitz version.

Akerlof and Yellen (1990) introduced fairness norms as a basis for efficiency wage models, and the survey evidence reported by Bewley (1999) strongly supports this approach. In a Shapiro-Stiglitz setting the fairness element can be captured by letting the perceived fairness of the wage influence the disutility of high effort. The interpretation is straightforward. The disutility of providing effort that benefits someone else depends on one’s feelings towards that someone; if the owners have been treating the CEO well, the disutility will be low.

Using this approach Skott and Guy (2013) show that shifts in pay norms – whatever the sources of the shift – can be a direct, non-market influence on the evolution of CEO pay. Moreover, an increase in pay to the CEO has no necessary, derived effects on the firm’s strategy or relative factor inputs. Thus, our analysis supports the emphasis on institutional and ideological factors (e.g. Atkinson 1998; Levy and Temin 2007; Piketty and Saez 2003; Mishel et al. 2012; Elson and Ferrere 2012).

5. Conclusions

Skill-biased shifts are commonly used to explain the trends in inequality and sky-rocketing CEO pay, in particular. The details differ but the essential element is that pay has increased because changes associated with new ICT have made profits increasingly sensitive to variations in the quality of the managerial input and/or have raised the reservation wage of high-skill managers. We find these skill-based explanations incomplete, at best. In corporate governance contexts the use of agency models is a standard way of modeling CEO pay, for good reason; the impact of new technologies is best approached by understanding how these technologies, and the consequent changes in market structure, affect the agency problems.

The new technologies, applied in deregulated markets, have accentuated the information asymmetry between managers and shareholders, creating winner-take-all markets, raising the sensitivity of profit to managerial effort and increasing uncertainty in the mapping of observed profit outcomes onto managerial effort; the norms and social comparisons which mediate the manager’s response to different pay outcomes are also institutionally constrained. The international diversity in levels and changes in inequality further testifies to the importance of this institutional contingency.

Footnotes

Acknowledgements

The authors would like to thank Frank Levy, Fred Moseley, and Mark Thoma for their comments on an earlier version of this paper.

*

Paper prepared for the ASSA meetings, San Diego, January 2013. A longer version of this paper is available as Working Paper 2013-01, Department of Economics, University of Massachusetts Amherst.

Declaration of Conflicting Interests

The author(s) declared no potential conflicts of interest with respect to the research, authorship, and/or publication of this article.

Funding

The author(s) received no financial support for the research, authorship, and/or publication of this article.

1

Truck drivers, for instance, have seen their power reduced as new technologies enable their employers to monitor their behavior more closely; as it says on the website of one of the manufacturer of the “Road Safety Fleet Black Box,” “it is like being able to sit next to every one of your drivers every second they drive” (http://www.roadsafety.com/fleet.php; see also, Burks and Guy, 2012.). No longer can a delay be blamed on bad weather or heavy traffic. Similar changes have taken place in a range of occupations from retail clerks to call centers. ICTs have also reduced collective power by making it easier to divert work around a particular work group or establishment.

2

We should note here that one factor encouraging this development was the growth of firm- and industry-level volatility, which made it less acceptable to keep pension obligations on a company’s own books; countries where most pensions were delivered by publicly managed pay-as-you go systems largely escaped both the move of pensions to the market, and the elevation of shareholder value maximization to the status of major public virtue ().

3

It is not clear that the existing managers are manifestly more skillful than other potential candidates. Commenting on the hearings of the Financial Crisis Inquiry Commission, Krugman (NYT 1/14/2010) observed:“Well, if you were hoping for a Perry Mason moment – a scene in which the witness blurts out: Yes! I admit it! I did it! And I’m glad! – the hearing was disappointing. What you got, instead, was witnesses blurting out: Yes! I admit it! I’m clueless! [it was] startling to hear Mr. Dimon admit that his bank never even considered the possibility of a large decline in home prices, despite widespread warnings that we were in the midst of a monstrous housing bubble.”

Author Biographies

Peter Skott is a professor of economics at the University of Massachusetts Amherst. His main fields of interest are macroeconomic dynamics and the distribution of income.

Frederick Guy is Senior Lecturer in the Department of Management, Birkbeck, University of London. His book The Global Environment of Business is published by Oxford University Press

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