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UCSC ECON 104 - CEO Salaries

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A. IntroductionB. Theory1. Marginal revenue Product2. Other possibilitiesC. How to test theories1. Choice of Variables2. Levels, differences or percent changes.3. Cross section or time series4. Linear or in Logs or in some other form.5. Contemporaneous data, lags or leads.D. DataE. Regressions1. Profits and CEO salaries2. Salary levels and profit3. Stock values as a predictor of CEO salaries4. Inappropriate regressionsF. Interpreting results1. Significance and importance2. Robustness3. Related research questionsG. Concluding thoughtsCEO SALARIES(CEO.dta)A. IntroductionToday we consider the determination of CEO salaries. This is topic that receives considerable attention in the popular press which often claims that managers are paid too much. If intermediate micro is correct, then managers like other workers are paid their marginal revenue product. But is economic theory correct, are there other theories, and how do we measure marginal product? The kind of intellectual exercise that we undertake for this course is considerably different than that experienced in other economics courses. In other economics courses, the students essentially spit back what they have been taught in lecture. For example, in a beginning statistics course you might calculate the linear regression given a certain set of numbers. In this course, you must integrate all of your knowledge from all of your economics courses. Furthermore, you are asked to be more original and creative -- that is what research is about. Unfortunately, creativity cannot be taught in lecture and you do not have the security blanket that you can look up the answer in the text or in class notes. Finally, there is no sense of closure as in many economics courses. There is no one answer that is right or complete. The art of econometrics is to deal with real data which are messy and often not what we really want. Answers are only tentative, until the next study comes along and refines the issue still further. The student must learn to deal with this sense of incompleteness.B. Theory1. Marginal revenue ProductWhat should salaries depend on? To maximize profits, a competitive firm should increase its output as long as the extra revenues exceed the extra costs (wages). In the market for CEO's, the stockholders should be willing to pay a dollar more for another CEO if that CEO brings in more than one dollar's worth of profits (not including the CEO's salary). This search will continue until the excess returns are exhausted and the salary of the chosen CEO equals her marginal revenue.2. Other possibilitiesEconometrics is more interesting when there are two or more competing theories to disentangle.A second theory, more popular in business schools than in economics departments, arguesthat CEO's try to rip off stockholders. The more diversified the stock-holders are, the more that this agency problem will arise. Diversification means that it is not in the interest of anyone stockholder to pay attention to agency problems. Hence, if one could get a measure of concentration of stockholdings, one might want to see whether greater concentration meant lower CEO salaries. Another measure might be the percentage of the Board of directors composed of insiders (that is, managers). A higher percentage would imply a higher pay for the CEO and other managers. However, typically compensation committees are composed only of outsiders. Even "outside" directors may not necessarily have the stockholders best interest in mind. They may go along with management because they are management themselves (in different companies). Are there any other ways that you can think of that CEO salaries should (or are) being determined? Can you think of other factors that might determine CEO salaries beyond productivity and the relative influence of the managers?C. How to test theories1. Choice of VariablesBefore even looking at the data, a very useful exercise is to consider all the variables that one might want to look at if all data were freely available. This exercise gets one to think about hypothesis testing, aids in searching for an appropriate data base, and allows one tocritically assess the quality of the data actually obtained.This involves deep thinking and a good understanding of economics. It is more than just listing variables. Let us consider the determination of CEO salaries. Two obvious contenders for determination of CEO salaries are profits and stock prices. While long term profits and stock prices are related, short term profits may not be at all similar to stock prices. A firm may undertake large investments which depress accountingprofits but the present value of these investments may swamp any current losses. Some start up firms have not made any money, but they expect to in the future; the CEO in sucha firm still receives a salary. Therefore from an economic theory standpoint, stock prices are more germane than profits. Still one would be surprised if profits had no effect on salaries, so economists are still likely to include profits as an explanatory variable in a multiple regression equation.Appreciation in stock prices is not the only relevant variable to stock holders. Stockholders are also interested in dividends. The more earnings are retained (the lower dividends are), the higher the stock price since the value of the company is that much higher. That is, dividends and stock appreciation from retained earnings are substitutes.Therefore, the researcher has to take into account the returns to the stock holder in the form of dividends, not just the increase in price of the stock.Other things beyond the control of the CEO may influence the price of the company's stock. Suppose that we are looking at changes in stock prices in the last three years and that there was an unanticipated downward shock in the automobile industry (the government decided to put a luxury tax on all new automobiles). Then the stock market performance of all automobile manufactures should drop. In this case, the relevant yardstick would be a comparison among automobile manufacturers, not corporations in general.One also needs to consider the exact specification of the variables. With regard to CEO compensation, does one just look at salaries or other forms of compensation such as stockoptions. Clearly, all forms of compensation are of importance but some forms of compensation involve severe measurement problems. For example, measuring stock options is tricky and


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