NBER WORKING PAPER SERIES

WHY HAS CEO PAY INCREASED SO MUCH?

Xavier Gabaix
Augustin Landier
Working Paper 12365
http://www.nber.org/papers/w12365
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
July 2006

[email protected], [email protected]. We thank Hae Jin Chung, Sean Klein and Chen Zhao for
excellent research assistance. For helpful comments, we thank Daron Acemoglu, Lucian Bebchuk, Olivier
Blanchard, Alex Edmans, Bengt Holmstrom, Hongyi Li, Kevin J. Murphy, Eric Rasmusen, Emmanuel Saez,
Andrei Shleifer, David Yermack, Frank Levy and Jeremy Stein and seminar participants at University of
Chicago, London School of Economics, MIT and the University of Southern California. We thank Carola
Frydman and Kevin J. Murphy for their data. XG thanks the NSF for financial support. The views expressed
herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic
Research.
2006 by Xavier Gabaix and Augustin Landier. All rights reserved. Short sections of text, not to exceed
two paragraphs, may be quoted without explicit permission provided that full credit, including notice, is
given to the source.

Why Has CEO Pay Increased So Much?

Xavier Gabaix and Augustin Landier
NBER Working Paper No. 12365
July 2006
JEL No. D2, D3, G34, J3
ABSTRACT
This paper develops a simple equilibrium model of CEO pay. CEOs have different talents and are
matched to firms in a competitive assignment model. In market equilibrium, a CEOs pay changes
one for one with aggregate firm size, while changing much less with the size of his own firm. The
model determines the level of CEO pay across firms and over time, offering a benchmark for
calibratable corporate finance. The sixfold increase of CEO pay between 1980 and 2003 can be fully
attributed to the six-fold increase in market capitalization of large US companies during that period.
We find a very small dispersion in CEO talent, which nonetheless justifies large pay differences. The
data broadly support the model. The size of large firms explains many of the patterns in CEO pay,
across firms, over time, and between countries.
Xavier Gabaix
Princeton University
Department of Economics
Bendheim Center for Finance
26 Prospect Ave, #211
Princeton, NJ 08540-5296
and NBER
[email protected]
Augustin Landier
New York University
Stern School of Business
Finance Department
44 West Fourth Street
New York, NY 10012-1126
[email protected]

This paper proposes a simple competitive model of CEO compensation. It is tractable

and calibratable. CEOs have dierent levels of managerial talent and are matched to firms
competitively. The marginal impact of a CEOs talent is assumed to increase with the value
of the firm under his control. The model generates testable predictions about CEO pay across
firms, over time, and between countries. Moreover, the model demonstrates that the recent
rise in CEO compensation may be an ecient equilibrium response to the increase in the
market value of firms, rather than resulting from agency issues.
In our equilibrium model, the best CEOs manage the largest firms, as this maximizes
their impact. The paper extends earlier work (e.g., Lucas 1978, Rosen 1981, 1982, 1992,
Tervio 2003), by drawing from extreme value theory to obtain general functional forms for the
spacings in the distribution of talents. This allows us to solve for the variables of interest in
closed form without loss of generality, and generate concrete predictions. Our central equation
predicts that a CEOs pay is increasing in both the size of his firm and the size of the average
firm in the economy. The cross-sectional relationship between firm size and compensation has
been well documented empirically. Moreover, the role of average firm size provides a novel
explanation of the rapid surge in US CEO pay since 1980. While previous papers attribute
this trend to incentive concerns or managerial entrenchment, we show that it can be explained
by the scarcity of CEO talent, competitive forces and the six-fold increase in firm size over
the same period.
Our model also sheds light on cross-country and cross-industry dierences in compensation.
It predicts that countries experiencing a lower rise in firm value than the US should also have
experienced lower executive compensation growth, which is consistent with European evidence
(e.g. Conyon and Murphy 2000). We show that a large fraction in cross-country dierences in
the level of CEO compensation can be explained by dierences in firm size. Within the US,
both firm size and the size of a benchmark firm within the industry are significant predictors
of CEO compensation.
Finally, we oer a calibration of the model, which could be useful to guide future quantitative models of corporate finance. The main surprise is that the dispersion of CEO talent
distribution appeared to be extremely small at the top. If we rank CEOs by talent, and
replace the top CEO by CEO number 250, the value of his firm will decrease by only 0.016%.
However, these very small talent dierences translate into considerable compensation dierentials, as they are magnified by firm size. The same calibration delivers that CEO number 1
is paid over 500% more than CEO number 250.

The rise in executive compensation has triggered a large amount of public controversy and
academic research. Our theory is to be compared with the three types of economic arguments
that have been proposed to explain this phenomenon.
The first explanation attributes the increase in CEO compensation to the widespread
adoption of compensation packages with high-powered incentives since the late 1980s. Both
academics and shareholder activists have been pushing throughout the 1990s for stronger
and more market-based managerial incentives (e.g. Jensen and Murphy 1990). According
to Inderst and Mueller (2005) and Dow and Raposo (2005), higher incentives have become
optimal due to increased volatility in the business environment faced by firms. Accordingly,
Cuat and Guadalupe (2005) document a causal link between increased competition and
higher pay-to-performance sensitivity in US CEO compensation.
In the presence of limited liability and/or risk-aversion, increasing performance sensitivity
requires a rise in the dollar value of compensation to maintain his participation. Holmstrom
and Kaplan (2001, 2003) link the rise of compensation value to the rise in stock-based compensation following the leveraged buyout revolution of the 1980s. However, this link between
the level and the slope of compensation has not been extensively calibrated1 . Given the
substantial cash-based compensation of top CEOs, it is unclear why increased incentives have
not been implemented through exchanging salary for securities, keeping total pay constant.
Similarly, CEOs large stocks of existing wealth likely lead to low risk aversion, and thus only
small increases in total compensation are required for them to accept a higher performancebased element. Our model explains the level of total compensation without appealing to eort
considerations. Incentives would determine, in a second and subordinate step, the relative mix
of total pay between salaries and incentives. This way, we derive a simple benchmark for the
pay-sensitivity estimates that have caused much academic discussion (Jensen and Murphy
1990, Hall and Liebman 1998, Murphy 1999, Bebchuk and Fried 2003).
Following the wave of corporate scandals and the public focus on the limits of the US
corporate governance system, a skimming view of CEO compensation has gained momentum
(Bertrand and Mullainathan 2001, Bebchuk and Fried 2003, 2004). The proponents of the
skimming view explain the rise of CEO compensation simply by an increase in managerial
entrenchment. When changing circumstances create an opportunity to extract additional
rentseither by changing outrage costs and constraints or by giving rise to a new means of
camouflagemanagers will seek to take full advantage of it and will push firms toward an
1

An exception is Gayle and Miller (2005) who estimate a structural model of executive compensation under
moral hazard.

equilibrium in which they can do so (Bebchuk et al. 2002). Stock-option plans are viewed
as a means by which CEOs can (ineciently) increasing their own compensation under the
camouflage of (eciently) improving incentives, and thus without encountering shareholder
resistance.
A milder form of the skimming view is expressed in Hall and Murphy (2003) and Jensen,
Murphy and Wruck (2004). They attribute the explosion in the level of stock-option pay
to an inability of boards to evaluate the true costs of this form of compensation. These
forces have almost certainly been at work, but it is unclear how important they are for the
typical firm (Holmstrom 2006). For instance, Rajan and Wulf (2006) challenge the view that
perks are pure managerial excess by showing that companies oer high perks precisely when
those are likely to be productivity-enhancing. In that spirit, the present paper oers a purely
competitive benchmark that explains the rise in US CEO compensation without assuming
changes in the extent of rent extraction. In our model, this rise is an equilibrium consequence
of the substantial increase in firm size. We also show in an extension how an underestimation
by some firms of the real cost of stock-options can aect the wage other firms have to pay.
A third type of explanation, perhaps more related to our paper, attributes the increase in
CEO compensation to changes in the nature of the CEO job. Garicano and Rossi-Hansbern
(2006) present a model where changes communication technology changes in managerial function and pay. Hermalin (2004) argues that the rise in CEO compensation reflects tighter corporate governance. To compensate CEOs for the increased likelihood of being fired, their pay
must increase. Frydman (2005) and Murphy and Zabojnik (2004) provide evidence that CEO
jobs have increasingly placed a greater emphasis on general rather than firm-specific skills.
Such a trend increases CEOs outside options, putting upward pressure on pay. However,
this explanation runs into quantitative diculties. Changes in the skill set of CEOs appear
small to moderate (Frydman 2005), while the level of CEO compensation has increased by
a factor of 5 to 10. Moreover, given the rise in the number of MBAs among executives and
the spread of executive education, it is doubtful that the scarcity of general skills is a major
factor explaining the rise in CEO compensation. By contrast, our model explains this increase
readily by the demand for top talent. When stock market valuations are 6 times larger, CEO
productivity is multiplied by 6, and total pay increases by 6 as firms compete to attract
talent.
Perhaps closest in spirit to our paper is Himmelberg and Hubbard (2000) who notice that
aggregate shocks might jointly explain the rise in stock-market valuations and the level of CEO

pay. However, their theory focuses on pay-to-performance sensitivity and the level of CEO
compensation is not derived as an equilibrium. By abstracting from incentive considerations,
we are able to oer a tractable, fully solvable model.
Our paper connects with several other literatures. One recent strand of research studies
the evolution of top incomes in many countries and over long periods (e.g. Piketty and Saez
2006). Our theory oers one way to make predictions about top incomes. It can be enriched by
studying the dispersion in CEO pay caused by the dispersion in the realized value of options,
which we suspect is key to understanding the very large increase in income inequality at the
top recently observed in several countries.2
Recent papers in asset pricing explore between labor income risk and asset prices (e.g.
Lustig and van Nieuwerburgh 2005, Santos and Veronesi 2006). Entrepreneurs and CEOs not
only have high human capital (which is likely correlated with equity prices) but also significant
wealth and thus impact on asset prices. Therefore, the correlation between human capital and
the market is an important source of risk for the aggregate economy.
The core model is in section I. Section II presents empirical evidence, and is broadly
supportive of the model. Section III proposes a calibration of the quantities used in the
model. Even though the dispersion in CEO talent is very small, it is sucient to explain large
cross-sectional dierences in compensation. Section IV presents various theoretical extensions
of the basic model, in particular allowing for heterogeneity in the perceived impact of CEOs
across firms, and extends the models to executives below the CEO. Section V concludes.

Basic model

I.A

A simple assignment framework

There is a continuum of firms and potential managers. Firm n [0, N] has size S (n) and
manager m [0, N] has talent T (m).3 As explained later, size can be interpreted as earnings
or market capitalization. Low n denotes a larger firm and low m a more talented manager:
S 0 (n) < 0, T 0 (m) < 0. In equilibrium, a manager of talent T receives total compensation of
W (T ). There is a mass n of managers and firms in interval [0, n], so that n can be understood
as the rank of the manager, or a number proportional to it, such as its quantile of rank.
2

The present paper simply studies the ex ante compensation of CEOs, not the dispersion due to realized
returns.
3
By talent, we mean the expected talent, given the track record and characteristics of the manager.

We consider the problem faced by a particular firm. The firm has baseline earnings of
a0 . (The level of a0 depends on the firms assets in place). At t = 0, it hires a manager of
talent T for one period. The managers talent increases the firms earnings according to:
a1 = a0 (1 + CT )

(1)

for some C > 0. C quantifies the eect of talent on earnings. We consider two polar cases.
First, suppose that the CEOs actions at date 0 impact earnings only in period 1. The
firms earnings are (a1 , a0 , a0 , ...). The firm chooses the optimal talent for its CEO, T , by
maximizing current earnings, net of the CEO wage W (T ).
max
T

a0
(1 + C T ) W (T )
1+r

Alternatively, suppose that the CEOs actions at date 0 impact earnings permanently. The
firms earnings are (a1 , a1 , a1 , ...). The firm chooses the optimal talent CEO T to maximize
the present value of earnings, discounted at the discount rate r, net of the CEO wage W (T ):
max
T

a0
(1 + C T ) W (T ) = M
r

Up to a constant, the two programs above are equivalent to:

max S C T W (T )
T

(2)

If CEO actions have a temporary impact, S = a0 / (1 + r), which approximates the firms
earnings (realized earnings are a1 ). Conversely, if the impact is permanent, S = a0 /r, which
is close to the market capitalization M of the firm. 4 For brevity, our baseline analysis refers
to size as market capitalization, but earnings are a second plausible interpretation.5
Specification (1) can be generalized. For instance, CEO impact could be modeled as
a1 = a0 + Ca0 T + independent factors, for a non-negative . 6 If large firms are more dicult

T
If the impact last for T periods, the formula is S = a0 1 (1 + r)
/r.
5
Eq. 15 rationalizes a potential way to ascertain if CEO impact is temporary (aecting current earnings)
or permanent (aecting market capitalization). One would run a regression of wages on earnings, sales, and
market capitalization, and see which variables dominate. Technological change, or fashions, may change the
relative strength of earnings or market capitalization in setting CEO pay. This leaves a free parameter that
may be useful in some cases. If firms believe stock market prices are too noisy to guide to corporate decisions,
they will use revenues and earnings.
6
As discussed by Shleifer (2004), another interpretation of CEO talent is ability to aect the markets
4

to change than small firms, then < 1. Decision problem (2) becomes:
max S C T W (T ) .
T

(3)

If = 1, the model exhibits constant returns to scale with respect to firm size. Constant
returns to scale is a natural a priori benchmark, owing to empirical support in estimations
of both firm-level and country-level production functions. Similarly, section II.A yields an
empirical estimate consistent with = 1. We therefore keep a general factor in our analyses,
but frequently focus on the constant returns to scale case, = 1.
We now turn to the determination of equilibrium wages, which requires us to allocate one
CEO to each firm. We call w (m) the equilibrium compensation of a CEO with index m. Firm
n, taking the compensation of each CEO as given, picks the potential manager m to maximize
net earnings:
max CS (n) T (m) w (m)
(4)
m

Formally, a competitive equilibrium consists of:

(i) a compensation function W (T ), which specifies the wage of a CEO of talent T ,
(ii) an assignment function M (n), which specifies the index m = M (n) of the CEO
heading firm n in equilibrium,
such that
(iii) each firm chooses its CEO optimally: M (n) arg maxm CS (n) T (m) w (T (m))
(iv) the CEO market clears, i.e. each firms gets a CEO. Formally, with CEO the measure
on the set of potential CEOs, and F irms the measure of set of firms, we have, for any
measurable subset a in the set of firms, CEO (M (a)) = F irms (a).
By standard arguments, an equilibrium exists. To solve for the equilibrium, we first
observe that, by the usual arguments, any competitive equilibrium is ecient, i.e maximizes
R
S (n) T (M (n)) dn, subject to the resource constraint. Second, any ecient equilibrium
involves assortative matching. Indeed, if there are two firms with size S1 > S2 and two CEOs
with talents T1 > T2 , the net surplus is higher by making CEO 1 head firm 1, and CEO
2 head firm 2. Formally, this is expressed S1 T1 + S2 T2 > S1 T2 + S2 T1 , which comes from
(S1 S2 ) (T1 T2 ) > 0. We conclude that in the competitive equilibrium, there is assortative
matching, so that CEO number n heads firm number n (M (n) = n).
perception of the earnings (e.g. the P/E ratio) rather than fundamentals. Hence, in moment of stock market
booms, if investors are over-optimistic in the aggregate, C can be higher. See also Malmendier and Tate (2005)
and Bolton et al. (forthcoming).

Eq. 4 gives CS (n) T 0 (m) = w0 (m). As in equilibrium, there is associative matching:

m = n,
w0 (n) = CS (n) T 0 (n) ,
(5)
which is a classic assignment equation (Sattinger 1993, Teulings 1995).
We normalize to 0 the reservation wage of the least talented CEO (n = N).7 Hence:
w (n) =

CS (u) T 0 (u) du

(6)

Specific functional forms are required to proceed further. We assume a Pareto firm size
distribution with exponent 1/:
S (n) = An
(7)
This fits the data reasonably well with ' 1, a Zipfs law. See section III and Axtell (2001),
Luttmer (2005) and Gabaix (1999, 2006) for evidence and theory on Zipfs law for firms.
Using Eq. 6 requires to know T 0 (u), the spacings of the talent distribution.8 As it seems
hard to have any it confidence about the nature, and distribution of talent, one might think
that the situation is hopeless. Fortunately, section I.B shows that extreme value theory gives
a definite prediction about the functional form of T 0 (u).

I.B

The talent spacings at the top: an insight from extreme value

theory

Extreme value theory shows that, for all regular continuous distributions, a large class
that includes all standard distributions (including uniform, Gaussian, exponential, lognormal,
Weibull, Gumbel, Frchet, Pareto), there exist some constants and B such that the following
equation holds for the spacings in the upper tail of the talent distribution (i.e., for small n):
T 0 (n) = Bn1 ,
7

(8)

If the outside opportunity wage of the worst executive is w0 , all wages are increased by w0 . This does
not change the conclusions at the top of the distribution, as w0 is likely to be very small compared to the
expressions derived in this paper.
8
We call T 0 (n) the spacing of the talent distribution because the dierence of talent between CEO of rank
n + dn and CEO of rank n is T (n + dn) T (n) = T 0 (n) dn.

Depending on assumptions, this equation may hold exactly, or up to a slowly varying

function as explained later.
The rest of this subsection is devoted to explaining (8), but can be skipped in a first
reading. We adapt the presentation from Gabaix, Laibson and Li (2005), Appendix A, and
recommend Embrechts et al. (1997) and Resnick (1987) for a textbook treatment.9 The
following two definitions specify the key concepts:
Definition 1 A function L defined in a right neighborhood of 0 is slowly varying if: u > 0,
limx0+ L (ux) /L (x) = 1.
Prototypical examples include L (x) = a or L (x) = a ln 1/x for a constant a. If L is slowly
varying, it varies more slowly than any power law x , for any non-zero .
Definition 2 The cumulative distribution function F is regular if f is dierentiable in a
neighborhood of the upper bound of its support, M R {+}, and the following tail index
of distribution F exists and is finite:
= lim

tM

d 1 F (t)
.
dt f (t)

(9)

We refer the reader to Embrechts et al. (1997, p.153-7) for the following Fact.
Fact 1 The following distributions are regular in the sense of Definition 2: uniform ( = 1),
Weibull ( < 0), Pareto, Frchet ( > 0 for both), Gaussian, lognormal, Gumbel, lognormal,
exponential, stretched exponential, and loggamma ( = 0 for all).
Fact 1 means that essentially all continuous distributions usually used in economics are
regular. In what follows, we denote F (t) = 1 F (t) . indexes the fatness of the distribution,
with a higher meaning a fatter tail.
< 0 means that the distributions support has a finite upper bound M, and for t in a left
neighborhood of M, the distribution behaves as F (t) (M t)1/ L (M t). This is the
case that will turn out to be relevant for CEO distributions. > 0 means that the distribution
is in the domain of attraction of the Frchet distribution, i.e. behaves similar to a Pareto:
F (t) t1/ L (1/t) for t . Finally = 0 means that the distribution is in the domain
9

Recent papers using concepts from extreme value theory include Gabaix, Gopikrishnan, Plerou and Stanley
(2003, 2006), Ibragimov (2005).

of attraction of the Gumbel. This includes the Gaussian, exponential, lognormal and Gumbel
distributions.

Let the random variable Te denote talent, and F its countercumulative distribution: P Te > t =
0

F
(t), and f (t) = F (t) its density. Call x the corresponding upper quantile, i.e. x =
P Te > t = F (t). The talent of CEO at the top x-th upper quantile of the talent distribution is the function T (x):
1
T (x) = F (x)
and therefore the derivative is:
1

T 0 (x) = 1/f F (x)

(10)

Eq. 8 is the simplified expression of the following Proposition, whose proof is in Appendix
B.
Proposition 1 (Universal functional form of the spacings between talents). For any regular
distribution with tail index , there is a B > 0 and slowly varying function L such that:
T 0 (x) = Bx1 L (x)

(11)

In particular, for any > 0, there exists a x1 such that, for x (0, x1 ) ,
Bx1+ T 0 (n) Bx1

(12)

We conclude that (8) should be considered a very general functional form, satisfied, to a
first degree of approximation, by any usual distribution. In the language of extreme value
theory, is the tail index of the distribution of talents, while is the tail index of the
distribution of firm sizes. Gabaix, Laibson and Li (2005, Table 1) contains a tabulation of the
tail indices of many usual distributions.
Eq. 8 allows us to be specific about the functional form of T 0 (x), at very low cost in
generality, and go beyond prior literature. Appendix B contains the proof of Proposition 1,
and shows that in limit cases, the slowly varying function L is actually a constant.10
From section I.C onwards, we will consider the case where Eq. 8 holds exactly, i.e.
10

If x is not the quantile, but a linear transform of it (b

x = x, for a positive constant ) then Proposition
h 1
i1
1
1 still applies: the new talent function is T (b
x) = F (b
x/), and T 0 (b
x) = f F (b
x/)
.

10

L (x) is a constant. When L (x) is simply a slowly varying function, the Propositions below
hold up to a slowly varying function, i.e. the right-hand size should be multiplied by slowly
varying functions of the inverse of firm size. Such corrections would significantly complicate
the exposition without materially aecting the predictions.

I.C

Implications for CEO pay

Using functional form (8), we can now solve for CEO wages. Equations 6, 7 and 8 imply:
w (n) =

A BCu+1 du =

A BC ()
n
N ()

(13)

In what follows, we focus on the case > .11

We consider the domain of very large firms, i.e. take the limit n/N 0, which gives:
w (n) =

A BC ()
n
,

(14)

a limit result that is formally derived in Appendix B. A Rosen (1981) superstar eect
holds. If > 0, the talent distribution has an upper bound, but wages are unbounded as
the best managers are paired with the largest firms, which allows them to command a high
compensation.
To interpret Eq. 14, we consider a reference firm, for instance firm number 250 the
median firm in the universe of the top 500 firms. Call its index n , and its size S(n ). We
obtain the following:
Proposition 2 (Level of CEO pay in the market equilibrium) Let n denote the index of a
reference firm for instance, the 250th largest firm. In equilibrium, for large firms (small n),
the manager of index n runs a firm of size S (n), and is paid:
w (n) = D (n ) S(n )/ S (n)/
11

(15)

If < , Eq. 13 shows that CEO compensation has a zero elasticity with respect to x for small x, so
that it has a zero elasticity with respect to firm size. Given that empirical elasticities are significantly positive,
we view the relevant case to be > .

11

where S(n ) is the size of the reference firm and

D (n ) =

Cn T 0 (n )

(16)

is independent of the firms size. In particular, the compensation in the reference firm is
w (n ) = D (n ) S(n )

(17)

Corollary 1 Proposition 2 implies the following:

1. Cross-sectional prediction: for a given year, compensation varies with firm size according
to S / .
2. Time-series prediction: compensation changes over time with the size of the reference
firm S(n ) .
3. Cross-country prediction: for a given firm size S, CEO compensation varies across countries, with the market capitalization of the reference firm, S(n )/ , using the same rank
n of the reference firm across countries.
0

Proof. As S = An , S(n ) = An
, n T (n ) = Bn , we can rewrite Eq. 14,

/ (/)
( ) w (n) = A BCn() = CBn An
An

= Cn T 0 (n ) S(n )/ S (n)/

The first prediction is cross-sectional. Starting with Roberts (1956), many empirical studies
(e.g. Baker, Jensen and Murphy 1988, Barro and Barro 1990, Frydman and Saks 2005,
Joskow et al. 1993, Kostiuk 1990, Rose and Shepard 1997, Rosen 1992) document that CEO
compensation increases as a power function of firm size w S , in the cross-section. A typical
empirical exponent is ' 1/3. 12 Baker, Jensen and Murphy (1988) call it best documented
12

As the empirical measures of size may be dierent from the true measure of size, the empirical may be
biased downwards, though it is unclear how large the biase is. In the extension in section IV.A, there is no
downwards bias. Indeed, suppose that the eective size is Si0 = Ci Si , so that ln wi = (ln Ci + ln Si ) + a for
a constant a. If Ci and Si are independent, regressing ln wi =
b ln Si + A will still yield an unbiased estimate
of .

12

empirical regularity regarding levels of executive compensation. We propose to name this

regularity Roberts law, and display it for future reference:
Roberts law for the cross-section: CEO Compensation Firm size

(18)

Eq. 15 predicts a Roberts law, with an exponent = /. 13 Section III will conclude
that the evidence suggests ' 1, ' 1 and ' 2/3.
The second prediction concerns the time-series. Eq. 15 predicts that wages depend on the
size of the reference firm to the power , S(n ) . For instance, in the U.S., between 1980 and
2000, the average market capitalization of the top 500 firms has increased by a factor of 6 (i.e.
a 500% increase). With = 1, the model predicts that CEO pay should increase by a factor
of 6.
This eect is very robust. Suppose all firm sizes S double. In Eq. 6, the right-hand side
is multiplied by 2 . Hence, the wages, in the left-hand side, are multiplied by 2 . The reason
is the shift in the willingness of top firms to pay for top talent. If wages did not change, all
firms would want to hire a more talented CEO, which would not be an equilibrium. To make
firms content with their CEOs, CEO wages need to increase, by a factor 2 .
The fact that the reference size S (n ) enters reflects the market equilibrium. The pay of a
CEOs depends not only of his own talent, but also on the aggregate demand for CEO talent,
which is captured by the reference firm
The contrast between the cross-sectional and time-series prediction should be emphasized.
Sattinger (1993) illustrates qualitatively this contrast in assignment models. Empirical studies
on the cross-sectional link between compensation and size (18) suggest ' 1/3. Therefore,
one might be tempted to conclude that, if all top firm sizes increase by a factor of 6, average compensation should be multiplied by 6 ' 1.8. However, and perhaps surprisingly, in
equilibrium, the time series eect is actually an increase in compensation of 6.
Third, the model predicts that CEOs heading similar firms in dierent countries will earn
dierent salaries.14 Suppose that the size S(n ) of the 250th U.K. firm is times smaller than
the size of the 250th U.S. firm ( = S US (n )/S UK (n )) and, to simplify, that the distribution
of talents at the top is the same. Then, according to Eq. 15, the salary of the US CEO should
13

Sattinger (1993, p.849) presents a model with a lognormal distribution of capital and talents, that predicts
a Roberts law with = 1.
14
Section IV.D discusses the potential impact of country size on the talent distribution at the top. In the
present analysis, we assume for simplicity an identical distribution of top talents across the countries compared
in the thought experiment, e.g. identically-sized countries.

13

be / higher than that of a British CEO running a firm of the same size.15
A direct implication of Proposition 2 is that the level of compensation should be sensitive
to aggregate performance, as it aects the demand for CEO talent. In addition, CEOs are
paid based on their expected marginal product, without necessarily any link with their ex
post performance. In ongoing work, we extend the model to incorporate incentive problems.
Proposition 2 still holds, for the expected value of the compensation. In this extension,
incentives may change the variability of the pay, but not its expected value.
While our model predicts an equilibrium link between pay and size, it does not imply that
a CEO would have an incentive the size of his company, for instance through acquisitions. His
talent, as perceived by the market, determines his pay, but the size of the company he directs
does not directly determine his pay.

II

Empirical Evidence

One motivation for our paper is the large increase in CEO compensation observed in the US
since the 1980s. We show that changes in firm size can explain the bulk of this phenomenon.
This section provides two further empirical tests of the relevance of our theory. First, within
the US, we look at whether our model can shed light on the cross-section of CEO pay. Second,
we document to what extent the cross-country dierences CEO pay can be explained by
dierences in firm sizes.

II.A

Time-Series Evidence for the USA, 1971-2004

Our theory predicts that the average CEO compensation (in a group of top firms) should
change in proportion to the average size of firms in that group, to the power . This section
shows that the USA evidence supports of this prediction, and is consistent with the benchmark
of constant returns to scale in the CEO production function, = 1.
In the USA, between 1980 and 2003, the average firm market value of the largest 500 firms
(debt plus equity) has increased (in real terms) by a factor of 6 (i.e. a 500% increase) as
documented in Appendix A.16 The model predicts that CEO pay should increase by a factor
of 6 .
15

This is qualitatively consistent with the findings of Conyon and Murphy (2000).
This increase in firm values results from the combination of an increase in earnings and price-earnings
ratios: earnings have increased by a factor 2.5 during that period (c.f. Appendix A).
16

14

To evaluate the changes in CEO pay, we use two dierent indices. The first one (JMW_compensation_
index) is based on the data of Jensen, Murphy and Wruck (2004). Their sample runs from
1970 onwards and is based on all CEOs included in the S&P 500, using data from Forbes and
ExecuComp. CEO total pay includes cash pay, restricted stock, payouts from long-term pay
programs and the value of stock options granted, using from 1992 on ExecuComps modified
Black-Scholes approach. This data set has some shortcomings. It does not include pensions.
Total pay prior to 1978 excludes option grants. Total pay between 1978 and 1991 is computed
using the amounts realized from exercising stock options, rather than grant-date values. The
latter can create a mechanical positive correlation between stock-market valuations and pay
in the short-run.
Our second compensation index (FS_compensation_index), based on the data from Frydman and Saks (2005) does not have this bias: it reflects solely the ex-ante value of compensation rather than its ex-post realization. FS_compensation_index sums cash compensation,
bonuses, and the ex ante (Black-Scholes value at date granted) of the indirect compensation,
such as options. However, this dataset includes fewer companies and is not restricted to CEOs.
The data are based on the three highest-paid ocers in the largest 50 firms in 1940, 1960 and
1990, a sample selection that is useful to make data collection manageable, but may introduce
some bias, as the criterion is forward looking. The size data for year t are based on the closing
price of the previous fiscal year as this is when compensation is set. In addition, we wish to
avoid any mechanical link between increased performance and increased compensation. Like
the Jensen, Murphy and Wruck index, the Frydman-Saks index does not include pensions.
The correlation of the mean asset value of the largest 500 companies in Compustat is 0.93
with FS_compensation_index and 0.97 with JMW_compensation_index. Apart from the
years 1978-1991 for JMW_compensation_index, there is no clear mechanical relation that
produces the rather striking similar evolution of firm sizes observed in Figure 1, as the indices
reflect ex-ante values of compensation at time granted (not realized values).
We estimate by the following regression, for the years 1970-2003:
t (ln wi,t ) =
bt ln Sn ,t1 + b ln wt1 + c ln Sn ,t1

The results are reported in Table 1 and are consistent with = 1.

Insert Table 1 about here

It would be highly desirable to study the US historical evidence before 1970 to provide
15

Executive Compensation and Market Cap of Top 500 Firms

3 4 5 6 7 8910

normalized to 1 in 1980

1970

1980

1990

2000

Year
JMW_compensation_index
mktcap500

FS_compensation_index

Figure 1: Executive Compensation and Market Capitalization of the top 500 Firms.
FS_compensation_index is based on Frydman and Saks (2005). Total Compensation is the
sum of salaries, bonuses, long-term incentive payments, and the Black-Sholes value of options granted. The data are based on the three highest-paid ocers in the largest 50 firms
in 1940, 1960 and 1990. JMW_compensation_index is based on the data of Jensen, Murphy
and Wruck (2004). Their sample encompasses all CEOs included in the S&P 500, using data
from Forbes and ExecuComp. CEO total pay includes cash pay, restricted stock, payouts
from long-term pay programs and the value of stock options granted, using from 1992 on
ExecuComps modified Black-Sholes approach. Compensation prior to 1978 excludes option
grants, and is computed between 1978 and 1991 using the amounts realized from exercising stock options. Size data for year t are based on the closing price of the previous fiscal
year. The firm size variable is the mean of the biggest 500 firm asset market values in Compustat (the market value of equity plus the book value of debt). The formula we use is
mktcap=(data199*abs(data25)+data6-data60-data74). Quantities are deflated using the Bureau of Economic Analysis GDP deflator.

16

additional tests of the model. The main sources are a book by Lewellen (1968), and the
recent working paper by Frydman and Saks (2005). The two studies are in some conflict.17
In particular, Lewellen (1968, p.147) finds a very high increase in before-tax compensation
in the 1950s, while Frydman and Saks find essentially no change during that period. It
appears that a key dierence is in the treatment of indirect compensation, particularly options
and pensions. Pensions are very high in the Lewellen study. Lewellen views the increased
importance of indirect compensation as a response to the very high marginal tax rates on direct
compensation: indirect compensation was taxed at a lower rate than direct compensation.
However, pensions are not included in Frydman and Saks (2005) study, making unobservable
a potentially important part of CEO compensation. In the end, we think it best to await
the resolution of these methodological and data issues (in particular the final version of the
Frydman-Saks project) to examine the past of US compensation. We now turn to the crosscountry evidence.

II.B

Panel Evidence for the USA, 1992-2004

Based on US data, we now study the model using both cross-sectional and time-series dimensions. We use the ExecuComp dataset (1992-2004), from which we retrieve information
on CEO compensation packages. We use ExecuComps total compensation variable, TDC1,
which includes salary, bonus, restricted stock granted and Black-Scholes value of stock-options
granted. Using Compustat, we retrieve firm size information and select each year the top
n = 500 and 1000 companies in total firm value (book value of debt plus equity market capitalization). We compute our measure of representative firm size, Sn ,t from this sample as
the value of the firm number n = 250 in our sample. We convert all nominal quantities into
constant 2000 dollars, using the GDP deflator from the Bureau of Economic Analysis.
Consider the i-th company (in size) at year t. We call Si,t its size and wi,t the level of
compensation of its CEO. Our model predicts (Proposition 2):

ln(Sn ,t ) + ( ) ln(Si,t ),
(19)

where the constant Di may depend on firm characteristics.18 We therefore regress compensation in year t on the size characteristics of firms as reported at the end of their fiscal year
t 1. This ensures that our size measure is not observed after the determination of CEO pay.
ln(wi,t+1 ) = ln Di +

17
18

We thank Carola Frydman for helpful conversations on this topic.

Eq. 23 gives the microfoundation for the term Di in this regression.

17

We perform three estimations of Eq 19. First, assuming that the sensitivity of performance to
talent (C) does not vary much across firms, Di = D, and therefore we can run the following
cross-sectional regression:
ln(wi,t+1 ) = d + e ln(Sn ,t ) + f ln(Si,t ) +

We provide estimates of the coecients of this OLS regression with t-stats clustered at
either the year level or at the firm level, as a same firm might appear for several years.
Second, we allow for the sensitivity of performance to talent to vary across industry and
therefore include industry fixed-eects, using the Fama and French (1997) 48 industry classification.
ln(wi,t+1 ) = dIndustry of firm i + e ln(Sn ,t ) + f ln(Si,t ) +

(20)

Third, we allow for firm fixed-eects, allowing for the performance to talent sensitivity to
be firm-specific.
Insert Table 2 about here
The results, reported in Table 2, are consistent with our theory. In particular, the industry
fixed-eect and firm fixed-eect specifications give an estimate of / quite compatible with
the back-of-the envelope calibration of section II.A, which suggest / 2/3. As Wald tests
indicate, all regressions are consistent with e + f = 1, i.e. a value = 1. There is nothing
mechanical that would force the estimate of to be close to 1.
Even though we are clustering at the year level, one might be concerned by the absence
of time fixed eects in our baseline regression. As a robustness check, we perform a twostep estimation: first, we include year dummies, without putting the reference size in the
regressors, i.e. estimate ln(wi,t+1 ) = d + f ln(Si,t ) + t + uit . Second, we regress the year
dummy coecient on the reference size, i.e. estimate t = e ln(Sn ,t ) + vt . The results are
essentially the same as those presented in Table 2 with the clustering at the year level.
A second type of concern is that the heteroskedasticity of residuals might aect the restimates of e and f . We apply the procedure recommended by Santos Silva and Tenreyro
(forthcoming), which is a form of maximum likelihood estimation. We find again extremely
close results.
As corporate governance has been identified as a potential explanation for excessive CEO
pay (see the survey in Bebchuk and Fried, 2004, Chapter 6), we also control in one of our
18

specifications for the Gompers, Ishii and Metrick (GIM, 2003) governance index, which
measures at the firm level the quality of corporate governance. A high GIM denotes poor
corporate governance. Our results on the impact of size are unaected by this control. The
coecient of 0.019, combined with the standard deviation of the GIM index of 2.6, means
that a one-standard deviation deterioration in the GIM index implies a 5.2% increase in CEO
compensation. Poor governance does increase CEO pay, but the eect seems small compared
to the dramatic changes experienced.
To be compatible with both the time-series and cross-sectional patterns of CEO compensation, the skimming view of CEO pay would have to generate Eq. 15. No such model
of skimming has been written so far. In particular, a simple technology where CEO rents
are a fraction of firm cash-flows (wit = Sit ) would not explain the empirical evidence as it
would counterfactually generate the same elasticity of pay to size in the time-series and the
cross-section.

II.C

Cross-Country Evidence

In most countries, public disclosure of executive compensation is either non-existent or much

less complete than in the US. This makes the collection of an international data set on CEO
compensation a highly dicult and country-specific endeavor. For instance Kaplan (1994)
collects firm-level information on director compensation, using ocial filings of large Japanese
companies at the beginning of the 1980s.
We rely on a survey released by Towers Perrin (2002), a leading executive compensation
consulting company. This survey provides levels of CEO pay across countries, for a typical
company with $500 million of sales in 2001. To obtain information on the characteristics of
a typical firm within a country, we use Compustat Global data for 2000. We compute the
median net income (DATA32) of the top 50 firms, which gives us a proxy for the countryspecific reference firm size. We choose net income as a measure of firm size, because market
capitalization is absent from the Compustat Global data set. We choose 50 firms, because
requiring a markedly higher number of firms would lead drop too many countries from the
sample. We convert these local currency values to dollars using the average exchange rate in
2001.
We then regress the log of the country CEO compensation on the log of country is reference
firm size and other controls:19
19

We anticipate the result from section IV.D, which indicates Eq. 21 should hold after controling for

19

ln wi = c + ln Sn ,i

(21)

The identifying assumption we make is that CEO labor markets are not fully integrated
across countries. This assumption seems reasonable across all the countries included in the
Towers Perrin data, except Belgium, which is fairly integrated with France and the Netherlands. We therefore exclude Belgium from our analysis.20 . The market for CEOs has become
more internationally integrated in recent years (for example, the English born Howard Stringer
is now the CEO of the Japanese company Sony, after a career in the US). However, if it were
fully integrated, we should find no eect of regional reference firm size in our regressions.
Insert Table 3 about here
The regression results, reported in Table 3, show that the variation in typical firm size explains about half of the variance in CEO compensation across countries. The results are robust
to controlling for population and GDP per capita, which interestingly become insignificant
when firm size is included.
One might be concerned that variations in family ownership across countries might be
largely responsible for cross-country dierences in CEO pay. We therefore ran regressions
controlling by the variable Family from La Porta, Lopez-de-Silanes and Shleifer (1999),
which measures the fraction of firms for which a person is the controlling shareholder for
the largest 20 firms in each country at the end of 1995. The variable is defined for 13 of our
sample of 17 countries. It has no significant predictive power on CEO income and does not
aect the level and significance of our firm size proxy.
We also try to control for social norms, as societal tolerance for inequality is often proposed
as an explanation for international salary dierences. Our social norm variable is based on the
World Value Surveys E035 question in wave 2000, which gives the mean country sentiment
toward the statement: we need larger income dierences as incentives for individual eort.
We find that this variable does not explain cross-country variation in CEO compensation.
population size.
20
In our basic regression (21), if include Belgium, the coecient remains significant ( = 0.21, t = 2.14),
albeit lower.

20

MEX

CAN

I TA
NLD
AUS
FRA BRA
DEU
SW E
CHE
ZAF
THA

GBR
JPN

KOR

lo g(comp ensatio n)
6
7

USA

CHN

6
log(firm size)
lcomp

Fitted values

Figure 2: CEO compensation versus Firm size across countries. Compensation data are from
Towers Perrin (2002). They represent the total dollar value of base salary, bonuses, and longterm compensation of the CEO of a company incorporated in the indicated country with
$500 million in annual sales. Firm size is the 2000 median net income of a countrys top 50
firms in Compustat Global.

21

III

A calibration, and the very small dispersion of CEO

talent

III.A

Calibration of , ,

We propose a calibration of the model. We intend it to represent a useful step in the long-run
goal of calibratable corporate finance, and for the macroeconomics of the top of the wage
distribution.
The empirical evidence and the theory on Zipfs law for firm size suggests ' 1 (Axtell
2001, Fujiwara et al. 2004, Gabaix 1999, 2006, Gabaix and Ioannides 2004, Ijiri and Simon
1977, Luttmer 2005). However, existing evidence measures firm size by employees or assets,
but not total firm value. We therefore estimate for the market value of large firms.
It is well established that Compustat suers from a retrospective bias before 1978 (e.g.
Kothari, Shanken and Sloan 1995). Many companies present in the data set prior to 1978
were in reality included after 1978. We therefore study the years 1978-2004.
For each year, we calculate the total market firm value, i.e. the sum of its debt and
equity; we define the total firm value as (data199*abs(data25)+data6-data60-data74). We
rank firms by total firm value, and order S(1) S(2) .... We study the best Pareto fit
for the top n = 500 firms. We estimate the exponent for each year by two methods:
P
the Hill estimator, Hill = (n 1)1 n1
i=1 ln S(i) ln S(n) , and OLS regression, where the
estimate is the regression coecient of: ln (S) = OLS ln(Rank1/2)+constant. Gabaix
and Ibragimov (2006) show that the 1/2 term is optimal and removes a small sample bias.
Figure 3 illustrates the log-log plot for 2004.
The mean and cross-year standard deviations are respectively: Hill : 1.095 (standard
deviation 0.063) and OLS : 0.869 (standard deviation 0.071). These results are consistent
with the ' 1 found for other measures of firm size, an approximate Zipfs law.
The time-series evidence of section II.A suggests the CEO impact is linear in firm size:
' 1.
The evidence on the firm-size elasticity suggests w S 1/3 , which by Eq. 15 implies
' 2/3.

22

6
ln(Rank-1/2)
2
4
0
2

4
5
Ln(Asset Market Value)
lnrank

Fitted values

Figure 3: Size distribution of the top 500 firms in 2004. In 2004, we take the top 500 firms
by total firm value (debt + equity), order them by size, S(1) S(2) ... S(500) , and plot
ln S on the horizontal axis, and ln (Rank 1/2) on the vertical axis. Gabaix and Ibragimov
(2006) recommend the 1/2 term, and show that it removes the leading small sample bias.
Regressing: ln(Rank1/2) = OLS ln (S) +constant, yields: OLS = 1.01 (standard error
0.063), R2 = 0.99. The ' 1 is indicative of an approximate Zipfs law for market values,
and leads to = 1/ ' 1 in the calibration.

23

f(T)

Tmax

Figure 4: Shape of the distribution of CEO talent inferred from the calibration. The calibration indicates that there is an upper bound Tmax , in the distribution of talents, and that
around Tmax the density f (T ) is proportional to (Tmax T )1/2 .
A value > 0 implies that the distribution has an upper bound Tmax , and that in the
upper tail, talent density is (up to a slowly varying function of Tmax T ):
P (T > t) = B 0 (Tmax t)1/ for t close to Tmax
With = 2/3, this means the density, left of the upper bound Tmax , is
f (T ) =

3B 0
(Tmax T )1/2 for t close to Tmax ,
2

a distribution illustrated in Figure 4.

It would be interesting to compare this square root distribution of (expected) talent it
to the distributions of more directly observable talents, such as professional athletes ability.
Even more interesting would be to endogenize the distribution T of talent, perhaps as the
outcome of a screening process, or another random growth process.

III.B

The dispersion of CEO talent

We next calibrate the impact of CEO talent. We index firms by rank, the largest firm having
rank n = 1. Formally, if there are N firms, the fraction of firms larger than S (n) is n/N:

24

e
P S > S (n) = n/N. The reference firm is the median firm in the universe of the top 500
firms. Its rank is n = 250.
The sample year is 2004. The median compensation amongst the top 500 best-paid CEOs
is w = $8.34 106 , where as elsewhere the numbers are expressed in constant 2000 dollars using the GDP deflator constructed by the Bureau of Economic Analysis. The market capitalization of firm n = 250 in 2003 is S(n ) = $25.0 109 . Proposition 2 gives

6 21
w = S(n ) BCn / ( ), so BC = ( ) w n
In
/S(n ) , i.e. BC = 2.8 10 .
6
the years 1992-2004, BC is quite stable, with a mean 3.10 10 and a standard deviation
0.44 106 .
Tervio (2003) backs out talent dierences in CEOs over a range.22 We answer his question
in our framework. The dierence of talent between the top CEO and the K-th CEO is:
T (1) T (K) =

K
0

T (n) dn =

Bn1 dn =

B
K 1

For K = 250, this dierences yields: BC (T (1) T (250)) = 0.016%. If firm number 1
replaced its CEO number 1 with CEO number 250, its market capitalization would go down
by 0.016%. This seemingly very small dierence in talent implies in our model that the pay
of CEO number 1 exceeds that of CEO number 250 by (250)1/ 1 = 2501/3 1 = 530%.
Substantial firm size leads to the economics of superstars, translating small dierences in
ability into very large deviations in pay.
Such a small measured dierence in talent might be due to measurement diculties. Here,
talent is the markets estimate of the CEOs talent, given noisy signals such as past performance. The distribution of true, unobserved talent is surely greater.23
Another way to put the finding of a very small talent dispersion is the following. If there
is a paradox in CEO pay, it is that firms must think that talent dierentials between the top
CEOs are surprisingly small. Otherwise, they would pay CEOs much more.
21

Proposition 4 indicates: w (n) = A BCn+ / ( ), which means that, if there are dierence Ci s,
the correct procedure to estimate C is to take firm size number n in the universe of all firms (which yields an
estimate of A via S (n) = An ), and salary number n in the universe of all CEO pay.
22
Baker and Hall (2004) also provide an estimate of CEO productivity, in a very dierent framework based
on incentive theory. The productivity of CEOs change with firm size in their model, but CEOs are all equally
talented.
23
Thus far, we have focused on our benchmark where a CEOs impact is permanent. In the temporary
impact interpretation, where CEO aects earnings for just one year, one multiplies the estimate of talent by
the price-earnings ratio. Taking an empirical price-earnings ratio of 15, replacing CEO number 250 by CEO
number 1 increases earnings by: 15 0.016% = 0.284%.

25

III.C

The sharing of the surplus between firms and managers

With our calibration, we can investigate how rents are divided between CEOs and shareholders. CEO number n, compared to CEO number K > n, increases the value of firm n by
CS (n) (T (n) T (K)), and earns additional salary of w (n)w (K). Therefore, in aggregate,
RK
CEOs more talented than CEO number K increase firm values by 0 CS (n) (T (n) T (K)) dn,
RK
and earn additional salary of 0 (w (n) w (k)) dn. Hence, the top K CEOs get a share of
the surplus equal to:
= RK
0

RK
0

(w (n) w (K)) dn

CS (n) (T (n) T (K)) dn

Surplus going to the top K CEOs

Total surplus created by the top K CEOs

(22)

Direct calculation of leads to a simple expression, formalized in the next Proposition.

Proposition 3 (Share of the surplus going to the top CEOs) For any K < N, the top K
CEOs earn a share of the surplus they create equal to = 1 , where is the tail exponent
of the distribution of firm size. Hence, with the benchmark values of Zipfs law ( = 1) and
constant returns to scale ( = 1), CEOs earn a vanishingly small share of the surplus.
With = 1 and = 0.98 (the mean of our two estimates of ), CEOs capture only 2% of
the surplus they create. Intuitively, when tends to 1, the average firm size and thus CEO
impact becomes infinite. However, average CEO pay remains finite, as it scales according to
an exponent less than 1. Hence, CEOs appropriate a vanishingly small fraction of the surplus.
Of course, as the surplus is very high, this vanishingly small fraction remains very large in
dollar terms.

IV

Extensions of the theory

We generalize our benchmark model to incorporate several real world dimensions. We start
with a generalization to the case of heterogeneous talent sensitivities across firms and use
this extension to study the compensation of executives below the CEO and the impact of the
compensation-setting of a subset of firms on the rest of the economy.

26

IV.A

Heterogeneity in Sensitivity to Talent across Assets

The impact of CEO talent might vary substantially with firm characteristics, even for a given
firm size. For example, the value of young high-tech companies might be more sensitive to
CEO talent that the value of a mature company of similar size. We therefore extend the model
to the case where C diers across firms.
Firm i solves the problem: maxT Si Ci T W (T ), where Ci measures the boards perception
(rational or irrational) of the strength of a CEO impact in firm i. Hence the problem is exactly
1/
that of section I, if applied to a firm whose eective size is Sbi = Ci Si .
We assume that CEO impact Ci and the size Si are drawn independently. This is a
relatively mild assumption, as a dependence of Ci with Si could already be captured by the
factor. We can now formulate the analogue of Proposition 2.
Proposition 4 (Level of CEO pay in market equilibrium when firms have dierent sensitivities to CEO talent) Call n a reference index of talent. In equilibrium, the manager of rank
n runs a firm whose eective size C 1/ S is ranked n, and is paid:
1/
/
/
w = D (n ) C S(n )
C 1/ S

(23)

with D (n ) = n T 0 (n ) / ( ), and S(n ) is the size of the reference firm, and C is the
e
following average over the firms sensitivity to CEO talent, C:
i
h
e1/()
C=E C

(24)

In particular, the reference compensation (compensation of manager n ) is:

w (n ) = D (n ) CS(n )

(25)

where S (n ) is the size of the n -th largest firm.

In the Proposition above, the n -th most talented manager will typically not head the
n -th largest firm (which has an idiosyncratic C), but Eq. 25 holds nonetheless.
1/
Proof. We need to calculate the analogue of (7) for the eective sizes Sbi = Ci Si . For
convenience, weset n to
be the upper quantile, so that the n associated with a firm of size s
satisfies n = P Se > s . The same reasoning holds if n is simply proportional to the upper
27

quantile, for instance is the rank. Then, by (7), n = P (S > s) = A1/ s1/ . In terms of
eective sizes, we obtain:

n = P Sb > s = P C 1/ S > s = P S > s/C 1/ = E P S > s/C 1/ | C
h

1/ i

= E A1/ s/C 1/
= A1/ E C 1/ s1/

b with A
b = AE C 1/ = AC 1/ .
Hence, the eective size at upper quantile n is Sb (n) = An
The rest is as in the proof of Proposition 2. In equilibrium, the n-th most talented manager
b . Equation 14 applies to
heads the firm with the nth highest eective size Sb (n) = An

e B ()
A
eective sizes, so manager n earns w (n) =
n
, which can be rewritten as (23).
Finally, manager n is paid:
w (n ) =

b B

A
Bn

n()
=
C An
= D (n ) CS(n )

Eq. 23 implies that one could measure the average Ci across an industry as the residual
of a regression of CEO pay on firm size. This may allow us to compare CEO impact between
industries.
Changes in compensation in a subset of firm may have important contagion eects to
the rest of the economy, as they force other firms to follow suit. Proposition 4 allows us study
examine this eect formally.

IV.B

Application: Contagion eects in CEO pay

If a fraction of firms wants to pay more than the other firms, how much does the
compensation of all CEOs increase? Suppose that a fraction f firms want to pay as
much than the other firms of similiar size. What happens to compensation in equilibrium?24
To analyze the question, we call type 0 the regular firms, and C0 their C, and C1 the
eective C of the fraction f of firms who want to pay as much as comparable firms. We
assume that those firms
independently of firm size. As in equilibrium, the CEO
are chosen

1/
pay is equal to w C1 S , with = /, a willingness to pay as much as the
24

We thank Jeremy Stein for asking us this question.

28

similarly-sized competitors means that:

/
C1

/
/
= fC1 + (1 f ) C0
/

as a fraction of f of firms pay an amount proportional to C1 , while a fraction 1 f pays

/

/
(1f )
C0 . We need f < 1; otherwise
an amount proportional to C0 . It follows: C1 = 1f
there is no equilibrium with finite salaries. By (24), the eective C is given by:
C/C0

"
#
1/()
(1 f )
= f
+1f
1 f

1/()
1 + O f 2 for f 0
= 1+f

(26)
(27)

Wages change by the ratio C/C0 . We summarize this in the following Proposition.
Proposition 5 Suppose that a fraction f of firms want to pay their CEO times as much
as similarly-sized firms. Then, the pay of all CEOs is multiplied by , with:
"
#
1/()
(1 f )
= f
+1f
1 f

(28)

To evaluate (28), we use the baseline values given by the models calibration, = = 1
and = 2/3. Taking a fraction of firms f = 0.1, = 2 gives = 2.03, and = 1/2
gives = 0.91, which shows the following result. If 10% of firms want to pay their CEO
only half as much as their competitors, then the compensation of all CEOs decreases by 9%.
However, if 10% of firms want to pay their CEO twice as much as their competitors, then the
compensation of all CEOs doubles.
The reason for this large and asymetric contagion eect is that a willingness to pay as
much as the other firms has an impact on the market equilibrium multiplied by 1/() =
3 , which is a convex and steeply increasing in the domain of pay raises, > 1. Given
that the magnitudes are potentially large, it would be good to investigate them empirically,
which would allow for a quantitative exploration of a view articulated by Shleifer (2004)
that competition in some cases exacerbates rather than corrects the impact of anomalous or
unethical behavior (see also Gabaix and Laibson 2006 for a related point).
The rest of this subsection studies related forms of contagion. To simplify the notations,
we consider the case = 1.
29

Competition from a new sector Suppose that a new fund management sector emerges
and competes for the same pool of managerial talent as the corporate sector. For simplicity,
say that the distribution of funds and firms is the same. The relative size of the new sector is
given by the fraction of fund per firm. We assume that talent aects a fund exactly as in
Eq. 2, with a common C. The aggregate demand for talent is therefore multiplied by (1 + ).
The pay of a given talent is multiplied by (1 + ), while the pay at a given corporate firm is
multiplied by (1 + )/ . Hence it is plausible that increases in the demand for talent, due to
the rise of new sectors (such as venture capital and money management) might have exerted
substantial upward pressure on CEO pay.
Strategic complementarity in compensation setting Suppose that the average perceived intensity of CEO impact, C, has increased by a factor > 1. What should be the
reaction of a firm F whose perceived sensitivity to talent C has remained unchanged? First,
if firm F wishes to retain its CEO, it needs to increase his pay by a factor , i.e. follow the
herd one for one. This is because firm F s CEO outside option is determined by the other
firms (as per Eq. 6), and has been multiplied by .
In a frictionless world, however, firm F would re-optimize, and hire a new CEO with lower
talent. Eq. 23 shows that the salary paid in firm F will still be higher than the previous
salary, by a factor / . Such a high degree of strategic complementarity may make the
market for CEO quite reactive to shocks, as initial shocks are little dampened.
We believe that the microstructure of CEO compensation setting is a promising avenue
for empirical research. Some firms might fix compensation by relying on compensation consulting firms that use formulas where size is an explicit determinant. Those formulas might
be in turn determined by cross-sectional regressions. When they hire a new CEO, firms have
to decide what level in the talent distribution they want to target. Conversely, firms who have
a CEO targeted by another firm have to decide whether they are willing to match his outside
oer or not. This implies that hiring wages are likely to have particularly high informational
content about the market forces that our model describes.
Misperception of the cost of compensation Hall and Murphy (2003) and Jensen, Murphy and Wruck (2004) have persuasively argued that at least some boards incorrectly perceived
stock options to be inexpensive because options create no accounting charge and require no
cash outlay. We now examine the impact of this misperception on compensation.
Consider if a firm believes that pay costs w/M rather than w, where M > 1 measures the
30

misperception of the cost of compensation. Hence Eq. 4 for firm i becomes maxm CSi T (m)
w (m) /Mi i.e.
max CMi Si T (m) w (m)
m

Thus, if the firms willingness to pay is multiplied by Mi , the eective C is now Ci0 = CMi .
The analysis of section IV applies: if all firms underestimate the cost of compensation by
= M, total compensation increases by . Even a rational firm that does not underestimate
compensation will increase its pay by / if it is willing to change CEOs, and if it wishes
to retain its CEO. Hence, other firms misperceptions aect a rational firm to a large degree.

IV.C

Executives below the CEO

Highly talented managers may occupy positions other than the CEO role. For example, a
division manager at General Electric might have a managerial talent index comparable to the
CEO of a relatively large company. It is therefore natural to generalize the model to the top
H executives of each firm. For that purpose, we consider the following extension of Eq. 1:
P
a1 /a0 = 1+ H
h=1 Ch Th . The h-th ranked executive improves firm productivity by his talent Th
and a sensitivity Ch , with C1 ... CH . There are no complementarities between the talents
of the various managers in our simple benchmark. In equilibrium, there will be assortative
matching, as very good managers work together in large firms, and less good managers work
together in smaller firms.
A firm of size S wants to hire H executives with talent (Th )h=1...H , to maximize its net
earnings:
H
H
X
X
S Ch Th
W (Th ) .
(29)
max
T1 ,...,TH

h=1

h=1

These are in fact H independent simple optimization problems:

max S Ch Th W (Th ) , for h = 1, ..., H
Th

In other words, each firm S can be considered as collection of single-manager firms with
1/
eective sizes (SCh )h=1...H to which the Proposition 4 can be applied. The next Proposition
describes the equilibrium outcome.
Proposition 6 (Extension of Proposition 2 to the top H executives). In the model where the
top H executives increase firm value, according to the first term of (29), the compensation of
31

the h-th executive h in firm i, is:

wi,h = D (n ) H 1

H
X

1/()
Ck

k=1

S(n )/ Si

1/()

Ch

(30)

with D (n ) = n T 0 (n ) / ( ).
Proof. The proof is simple, given Proposition 4. As per Eq. 29, each firm behaves as H
1/
independent firms, with eective
size Sih = Ch Si , h = 1...H. The average productivity (24)
P
1/
is now: C = H 1 H
. So
k=1 Ck
/
1/
/
1/
w (n) = D (n ) C S(n )
Ch Si
!

H
X
1/
1/
1
= D (n ) H
Ck
S(n )/ S (n)/ Ch
k=1

and the h-th executive in firm i earns (30).

In a given firm, the ratio between the CEOs pay and that of the h-th executive is
(C1 /Ch )1/ . Hence, within a firm, the relative marginal productivity of an executive (Ch )
can be inferred from his relative wages, according to: w1 /wh = (C1 /Ch )1/ . It would be
interesting to unite this with other ideas in the organization of a firm, e.g. Garicano and
Rossi-Hansberg (2006).
Rajan and Wulf (forthcoming) document a flattening of large American firms in the 1990s.
More executives report directly to the CEO and their more prominent position in the organization also translates into higher wages. In our framework, the increased role played by
managers below the CEO in value creation could be modeled as a smaller C1 /Ch . It could be
empirically related to the flattening of compensation (smaller w1 /wh ).
One could extend the impact to the full hierarchy of a firm, which would generate that large
firms pay more, because they hire more talented workers. This is consistent with evidence
from Fox (2006).25
25

The firm-size elasticity of the wages of average workers is much smaller, around 0.05 (Jeremy Fox, personal
communication).

32

IV.D

Country size, talent at the top, and the population passthrough

How does Proposition 2 change when the population size varies? To answer the question, it
is useful to distinguish between the total population, which we denote P , and, the eective
population from which CEOs of the top firms are drawn, Ne . One benchmark is that the
top CEOs are drawn from the whole population without preliminary sorting, i.e. Ne =
P . Another polar benchmark is that, the talent distribution in the, say, top 1000 firms, is
independent of country size. Then Ne = a for some constant a.26 It is convenient to unify
those two examples, and define the population pass-through [0, 1] in the following
way. When the underlying population is P , the eective number of potential CEOs that top
firms consider is Ne = aP for some a. In the first benchmark, = 1, while in the second
benchmark, = 0. In other terms, there is a production function of CEOs. We do not study
here the determinants of that production function.
The next Proposition shows that Proposition 2 holds, except that the constant D (n ) now
scales as P . A large population leads to an increased supply of top talent, and therefore
a fall in CEO pay. The impact is modulated by the pass-through , and the tail exponent of
the talent distribution, .
Proposition 7 (Dependence of population size of the level of CEO pay in the market equilibrium) Call P the total population, and assume that the number of candidate CEOs is
Ne = aP , where is the population pass-through, and that their talents are drawn from
a distribution independent of country size. Let n denote the index of a reference firm. In
equilibrium, for large firms (small n), the manager of index n runs a firm of size S (n), and
is paid:
w (n) = D (n ) S(n )/ S (n)/
(31)
where S(n ) is the size of the reference firm, and the dependance with population size is
captured by:
a bCn

P .
(32)
D (n ) =

26

This is the case, for instance, if managers have been selected in two steps. First, potential CEOs have to
have served in one of the top five positions at one of the top 10,000 firms, where those numbers are simply
illustrative. This creates the initial pool of 50,000 potential managers for the top 1000 firms. Then, their new
talent is drawn. This way, the eective pool from which the top 1000 CEOs are drawn does not scale with the
general of the population, but is simply a fixed number, here 50,000.

33

Proof. If Ne candidate
are
CEOs
drawn from a distribution with counter-cumulative1distribu1
tion F , such that 1/f F (x) = bB 1 , the talent of CEO number n is T (n) = F (n/Ne ),
and27
1
1
1
n
0
1
=b
T (n) =
= Bn1
Ne
Ne
N f F (n/N )
e

with B = bNe = a bP , so that D (n ) = BCn

bCn
/ ( ).
/ ( ) = a
P

The second regression in Table 3 provides a way to estimate , bearing in mind that
international data is of poor quality. The regression coecient of CEO compensation on log
population should be . We find a regression coecient of = 0.16 (s.e. 0.091),
which, with = 2/3, yields = 0.24 (s.e. 0.14). We are unable to reject = 0, and it seems
likely that is less than 1. A dynamic extension of the model is necessary to study further
this issue, in particular to understand the link between P and Ne , and we leave this to further
research.

IV.E

Generalization to other markets

It is easy to generalize the model to other superstars, such as entertainers, athletes, or, in the
context of real estate, very desirable locations. One could interpret S as various forums (e.g.,
tournaments, TV shows) in which superstars can perform. The same universal functional
form for talent or excellence (8) applies, and the decision problem remains similar. There are
now detailed studies of the talent markets for bank CEOs (Barro and Barro 1990), lawyers
(Garicano and Hubbard 2005), software programmers (Andersson et al. 2006), rock and roll
stars (Krueger 2005), movies and actors (de Vany 2004). It would be interesting to apply the
analytics of the present paper to these markets, measure the , and parameters, and see
to what extent variations in the sizes of stakes (size of banks, size of contested amounts in
lawsuits, concert revenues, movie revenues, or even ideas, see Jones 2005 and Kortum 1997)
explain the evolution in top pay in these markets.
27

Here we consider the case

where
the slowly varying function L of section I.B is a constant. The general
1
case is straightforward: 1/f F (x) = bB 1 L (x), and T 0 (n) = Bn1 L (n).

34

Conclusion

We provide a simple, calibratable competitive model of CEO compensation. The principal

contribution is that it can explain the recent rise in CEO pay as an equilibrium outcome
of the substantial growth in firm size. Our model diers from other explanations that rely
on managerial rent extraction, greater power in the managerial labor market, or increased
incentive-based compensation. The model can be generalized to the top executives within a
firm and extended to analyze the impact of outside opportunities for CEO talent (such as
the money management industry), and the impact of misperception of the cost of options on
the average compensation. Finally, the model allows us to propose a calibration of various
quantities of interest in corporate finance and macroeconomics, the dispersion and impact of
CEO talent.

35

Appendix A. Increase in firm size between 1980 and 2003

The following table documents the increase, in ratios, of mean and median value and earnings
of the largest n firms of the Compustat universe (n = 100, 500, 1000) between 1980 and
2003, as ranked by firm value. All quantities are real, using the GDP deflator. We measure
firm value as the sum of equity market value at the end of the fiscal year and proxy the
debt market value by its book value as reported in Compustat. Earnings are measured as
Operating Income (also called Earnings before income and taxes, EBIT), i.e. the value of a
firms earnings before taxes and interest payments (data13-data14). For instance, the median
EBIT of the top 100 firms was 2.7 times greater in 2003 than it was in 1980. As a comparison,
between 1980 and 2003, US GDP increased by 100% (source: Bureau of Economic Analysis).
Table 4: Increase in firm size between 1980 and 2003
1980-2003 increase in:

Firm Value

Operating Income

Median Mean Median Mean

Top 100
Top 500
Top 1000

630%
400%
440%

700%
540%
510%

170%
140%
120%

150%
150%
150%

Appendix B. Complements on extreme value theory

Proof of Proposition 1. The first step for the proof was to observe (10). The expression
1

for f F (x) is easy to obtain, e.g. from the first Lemma of Appendix B of Gabaix, Laibson
and Li (2005), which itself comes straightforwardly from standard facts in extreme value
theory. For completeness, we transpose the arguments in Gabaix, Laibson and Li (2005). Call
1
1
t = F (x) , j(x) = 1/f (F (x)):

1
0
f
F
(x)
d 1
d
1
F (x)
xj 0 (x)/j(x) = x ln f (F (x)) = x
1
dx
f (F (x)) dx
= xf 0 (F

(x))2

0
= F (t)f 0 (t)/f (t)2 = F /f (t) 1
(x))/f (F

36

log T'HxL
8
7
6
5
x
0.002

0.004

0.006

0.008

0.01

Figure 5: Illustration of the quality of the extreme value theory approximation for the spacings
in the talent distribution. x is the upper quantile of talent (only a fraction x of managers have
a talent higher than T (x)). Talents are drawn from a standard Gaussian. The Figure plots
the exact value of the spacings of talents, T 0 (x), and and the extreme value approximation
(Proposition 1), T 0 (x) = Bx1 , with = 0 (the tail index of a Gaussian distribution), B
makes the two curves intersect at x = 0.05.

0
so limx0 xj 0 (x)/j(x) = limtM F /f (t) 1 = 1. Because of Resnick (1987, Prop.
0.7.a, p. 21 and Prop. 1.18, p.66), that implies that j has regular variation with index 1,
so that (11) holds.28 Expression (12) comes from the basic characterization of a slowly varying
function (Resnick 1987, Chapter 0).
To illustrate Proposition 1, we can give a few examples. For > 0, the prototype is a Pareto
distribution: F (t) = kt1/ . Then T (x) = (k/x) . L (x) is a constant, L (x) = k . For < 0,
the prototypical example is a power law distribution with finite support: F (t) = k (M t)1/ ,
for t < M < . A uniform distribution corresponds to = 1. L (x) is a constant, L = k .
Another simple case is that of an exponential distribution: F (t) = e(tt0 )/k , for k > 0, which
has tail exponent = 0. Then, T 0 (x) = k/x, and L (x) = k, a constant.
A last case of interest is that of a Gaussian distribution of talent Te N (, 2 ), which
has tail exponent = 0. With and respectively the density and the cumulative of a
standard Gaussian, T (x) = + 1 (x), T 0 (x) = / (1 (x)), and standard calculations
p
show T 0 (x) = x1 L (x) with L (x) / 2 ln (1/x). Figure 5 shows the fit of the extreme
value approximation.
The language of extreme value theory allows us to state the following Proposition, which
is the general version of Eq. 14.
28

One can check that the result makes sense, in the following way: If j (x) = Bx1 , for some constant B,
then limx0 xj 0 (x)/j(x) = 1.

37

Proposition 8 Assume > . In the domain of top talents, (n small enough), the pay of
CEO number n is:
A BC ()
w (n) =
n
L (n) ,

for a slowly varying function L (n).
Proof. This comes from Proposition 1 and Eq. 6, and standard results on the integration of
functions with regular variations (Resnick, 1987, Chapter 0).

References
Andersson, Fredrik; Freedman, Matthew; Haltiwanger, John and Shaw, Kathryn.
Reaching for the Stars: Who Pays for Talent in Innovative Industries? Stanford University, Working Paper, 2006.
Axtell, Robert. Zipf Distribution of U.S. Firm Sizes. Science, 2001, 293 (5536), pp.
1818-20.
Baker, George; Jensen, Michael and Murphy, Kevin. Compensation and Incentives:
Practice vs. Theory. Journal of Finance, 1988, 43 (3), pp. 593-616.
Baker, George P. and Hall, Brian J. CEO Incentives and Firm Size. Journal of Labor
Economics, 2004, 22 (4), pp. 767-98.
Barro, Jason R. and Barro, Robert J. Pay, Performance, and Turnover of Bank CEOs.
Journal of Labor Economics, 1990, 8 (4), pp. 448-481.
Bebchuk, Lucian and Fried, Jesse. Executive Compensation as an Agency Problem.
Journal of Economic Perspectives, 2003, 17 (3), pp. 71-92.
Bebchuk, Lucian and Fried, Jesse. Pay without Performance: The Unfulfilled Promise
of Executive Compensation. Cambridge, MA: Harvard University Press, 2004.
Bebchuk, Lucian; Fried, Jesse and Walker, David. Managerial Power and Rent Extraction in the Design of Executive Compensation. University of Chicago Law Review,
2002, 69 (3), pp. 751-846.

38

Benhabib, Jess and Bisin, Alberto. The Distribution of Wealth and Redistributive
Policies. New York University, Working Paper, 2006.
Bertrand, Marianne and Mullainathan, Sendhil. Are CEOs Rewarded for Luck?
The Ones Without Principles Are. Quarterly Journal of Economics, 2001, 116 (3), pp.
901932.
Bolton, Patrick; Scheinkman, Jose and Xiong, Wei. Executive Compensation and
Short-termist Behavior in Speculative Markets. Review of Economic Studies, forthcoming.
Conyon, Martin and Murphy, Kevin. The Prince and the Pauper? CEO Pay in the
United States and United Kingdom. Economic Journal, 2000, 110 (8), pp. 640-671.
Cuat, Vicente and Guadalupe, Maria. Globalization and the provision of incentives
inside the firm. Columbia University, Working Paper, 2005.
De Vany, Arthur S. Hollywood economics: How extreme uncertainty shapes the film industry. London; New York: Routledge, 2004.
Dow, James and Raposo, Clara C. CEO Compensation, Change, and Corporate Strategy. Journal of Finance, forthcoming.
Embrechts, Paul; Kluppelberg, Claudia and Mikosch, Thomas. Modelling Extremal
Events. New York: Springer Verlag, 1997.
Fama, Eugene, and French, Kenneth. Industry Costs of Equity. Journal of Financial
Economics, 1997, 43 (2), pp. 153-93.
Fox, Jeremy T. Explaining Firm Size Wage Gaps with Equilibrium Hierarchies. University of Chicago, Working Paper, 2006.
Frydman, Carola. Rising Through the Ranks. The Evolution of the Market for Corporate
Executives, 1936-2003. Harvard University, Working Paper, 2005.
Frydman, Carola and Saks, Raven. Historical Trends in Executive Compensation,
1936-2003. Harvard University, Working Paper, 2005.

39

Fujiwara, Yoshi; Di Guilmi,Corrado; Aoyama, Hideaki; Gallegati, Mauro and

Souma, Wataru. Do ParetoZipf and Gibrat Laws Hold True? An Analysis with
European Firms. Physica A, 2004, 335 (1-2), pp. 197-216.
Gabaix, Xavier. Zipfs Law for Cities: An Explanation. Quarterly Journal of Economics,
1999, 114 (3), pp. 739-67.
Gabaix, Xavier. A Simple Model for Zipfs Law for Firms, Massachusetts Institute of
Technology, Working Paper, 2006.
Gabaix, Xavier; Gopikrishnan, Parameswaran; Plerou, Vasiliki and Stanley, H.
Eugene. A Theory of Power Law Distributions in Financial Market Fluctuations.
Nature, 2003, 423 (6937), pp. 267230.
Gabaix, Xavier; Gopikrishnan, Parameswaran; Plerou, Vasiliki and Stanley, H.
Eugene. Institutional Investors and Stock Market Volatility. Quarterly Journal of
Economics, 2006, 121 (2), pp. 461504.
Gabaix, Xavier and Ibragimov, Rustam. Rank-1/2: A Simple Way to Improve the
OLS Estimation of Tail Exponents, Harvard University, Working Paper, 2006.
Gabaix, Xavier and Ioannides, Yannis. The Evolution of the City Size Distributions,
in Vernon Henderson and Jacques-Franois Thisse, eds. Handbook of Regional and Urban
Economics, Vol. 4. Oxford: Elsevier Science, 2004, pp. 2341-2378.
Gabaix, Xavier and Laibson, David. Shrouded Attributes, Consumer Myopia, and
Information Suppression in Competitive Markets. Quarterly Journal of Economics,
2006, 121 (2), pp. 505-540.
Gabaix, Xavier; Laibson, David and Li, Hongyi. Extreme Value Theory and the Effects of Competition on Profits. Massachusetts Institute of Technology, Working Paper,
2005.
Garicano, Luis and Hubbard, Thomas N. Learning About the Nature of Production
from Equilibrium Assignment Patterns. University of Chicago, Graduate School of
Business, Working Paper, 2005.
Garicano, Luis and Rossi-Hansberg, Esteban. Organization and Inequality in a
Knowledge Economy. Quarterly Journal of Economics, forthcoming.
40

Gayle, George-Levi and Miller, Robert A. Has Moral Hazard Become a More Important Factor in Managerial Compensation? Carnegie-Mellon University, Working Paper,
2005.
Gompers, Paul A.; Ishii, Joy L. and Metrick, Andrew. Corporate Governance and
Equity Prices. Quarterly Journal of Economics, 2003, 118 (1), pp. 107-155.
Hall, Brian and Liebman, Jerey. Are CEOs Really Paid Like Bureaucrats? Quarterly
Journal of Economics, 1998, 113 (3), pp. 653-691.
Hall, Brian J. and Murphy, Kevin J. The Trouble with Stock Options. The Journal
of Economic Perspectives, 2003, 17 (3), pp. 49-70.
Hermalin, Benjamin E. Trends in Corporate Governance. Journal of Finance, forthcoming.
Himmelberg, Charles P. and Hubbard, R. Glenn. Incentive Pay and the Market for
CEOs: An Analysis of Pay-for-Performance Sensitivity. Columbia University, Working
Paper, 2000.
Holmstrm, Bengt. Pay without Performance and the Managerial Power Hypothesis: A
Comment. Massachusetts Institute of Technology, Working Paper, 2006.
Holmstrm, Bengt and Kaplan, Steven. Corporate Governance and Merger Activity
in the U.S. Journal of Economic Perspectives, 2001, 15 (2), pp. 121-44.
Holmstrm, Bengt and Kaplan, Steven. The State of U.S. Corporate Governance:
Whats Right and Whats Wrong? Journal of Applied Corporate Finance, 2003, 15(3),
pp. 8-20.
Ibragimov, Rustam. A Tale of Two Tails: Peakedness Properties In Inheritance Models
of Evolutionary Theory. Harvard University, Working Paper, 2005.
Ijiri, Yuji and Simon, Herbert A. Skew distributions and the sizes of business firms.
Amsterdam; New York: Elsevier/North-Holland, 1977.
Inderst, Roman and Mueller, Holger. Keeping the Board in the Dark: CEO Compensation and Entrenchment, Unpublished Paper, New York University, 2005.

41

Jensen, Michael and Murphy, Kevin J. Performance Pay and Top-Management Incentives. Journal of Political Economy, 1990, 98 (2), pp. 225-64.
Jensen, Michael; Murphy, Kevin J. and Wruck, Eric. Remuneration: Where weve
been, how we got to here, what are the problems, and how to fix them. Unpublished
Paper, 2004.
Jones, Charles I. The Shape of Production Functions and the Direction of Technical
Change. Quarterly Journal of Economics, 2005, 120 (2), pp. 517-549.
Joskow, Paul, Nancy Rose, Andrea Shepard. Regulatory Constraints on CEO Compensation. Brookings Papers on Economic Activity. Microeconomics, 1993, (1), pp.
1-58.
Kaplan, Steven. Top Executive Rewards and Firm Performance: A Comparison of Japan
and the United States. Journal of Political Economy, 1994, 102 (3), pp. 510-46.
Kortum, Samuel S. Research, Patenting, and Technological Change. Econometrica,
1997, 65 (6), pp. 13891419.
Kostiuk, Peter F. Firm Size and Executive Compensation. Journal of Human Resources,
1990, 25 (1), pp. 91105.
Kothari, S. P.; Shanken, Jay and Sloan, Richard G. Another Look at the CrossSection of Expected Stock Returns. Journal of Finance, 1995, 50 (1) pp. 185-224.
Krueger, Alan B. The Economics of Real Superstars: The Market for Rock Concerts in
the Material World. Journal of Labor Economics, 2005, 23 (1), pp. 1-30.
La Porta, Raphael; Lopez-deSilanes, Florencia and Shleifer, Andrei. Corporate
Ownership around the World. The Journal of Finance, 1999, 54 (2), pp. 471-517.
Lewellen, Willbur G. Executive Compensation in Large Industrial Corporations. New
York: National Bureau of Economic Research,1968.
Li, Fei and Masako Ueda, Endogenous Mathching in Principal-Agent Theory with an
Application to Executive Compnsation, Working Paper, University of Wisconsin.

42

Lucas, Robert E., Jr. On the Size Distribution of Business Firms. Bell Journal of
Economics, 1978, 9 (2), pp. 508523.
Lustig, Hanno and Van Nieuwerburgh, Stijn. The Returns on Human Capital: Good
News on Wall Street is Bad News on Main Street. Unpublished Paper, 2005.
Luttmer, Erzo G. J. The Size Distribution of Firms in an Economy with Fixed and Entry
Cost. Minneapolis Federal Reserve Bank, Working Paper Series: No. 633, 2005.
Malmendier, Ulrike and Tate, Georey. Superstar CEOs. Stanford University, Working Paper, 2005.
Murphy, Kevin J. Executive Compensation, in Orley Ashenfelter and David Card, eds.,
Handbook of Labor Economics, Vol. 3b. New York and Oxford: Elsevier Science North
Holland, 1999, pp. 2485-2563.
Murphy, Kevin J. and Zabojnik, Jan. CEO Pay and Appointments: A Market-based
explanation for recent trends. American Economic Review Papers and Proceedings,
2004, 94 (2), pp. 192-96.
Piketty, Thomas and Saez, Emmanuel. The evolution of top incomes: A historical
and international perspectives. American Economic Review, 2006, 96 (2), pp. 200-205.
Rajan, Raghu and Wulf, Julie. The Flattening Firm: Evidence from Panel Data on
the Changing Nature of Corporate Hierarchies. Review of Economics and Statistics,
forthcoming.
Rajan, Raghu and Wulf, Julie. Are perks purely managerial excess? Journal of Financial Economics, 2006, 79 (1), pp. 133.
Resnick, Sidney. Extreme Values, Regular Variation, and Point Processes. New York:
Springer Verlag, 1987.
Roberts, David R. A General Theory of Executive Compensation Based on Statistically
Tested Propositions. Quarterly Journal of Economics, 1956, 70 (2), pp. 270-294.
Rose, Nancy L. and Shepard, Andrea. Firm Diversification and CEO Compensation:
Managerial Ability or Executive Entrenchment? The RAND Journal of Economics,
1997, 28 (3), pp. 489-514.
43

Rosen, Sherwin. The Economics of Superstars. American Economic Review, 1981, 71 (3),
pp. 845858.
Rosen, Sherwin. Authority, Control and the Distribution of Earnings. Bell Journal of
Economics, 1982, 13 (2), pp. 311323.
Rosen, Sherwin. Contracts and the Market for Executives, in Lars Werin and Hans
Wijkander, eds., Contract Economics. Cambridge, MA and Oxford: Blackwell, 1992,
pp. 181211.
Santos, Jesus and Veronesi, Pietro. Labor Income and Predictable Stock Returns.
Review of Financial Studies, 2006, 19 (1), pp. 1-44.
Santos Silva, Joao and Tenreyro, Silvana. The Log of Gravity, Review of Economics
and Statistics, forthcoming.
Sattinger, Michael. Assignment Models of the Distribution of Earnings. Journal of
Economic Literature, 1993, 31 (2), pp. 831880.
Shleifer, Andrei. Does Competition Destroy Ethical Behavior? American Economic
Review, Papers and Proceedings, 2004, 94 (2), pp. 414-418.
Tervio, Marko. The Dierence that CEOs Make: An Assignment Model Approach.
Working Paper, University of California, Berkeley, 2003.
Towers Perrin. Worldwide Total Remuneration 2001-2002, Towers Perrin, Research
Report, 2002.

44

Table 1: CEO pay and the size of large firms, 1970-2003

ln Market
ln Compensation(-1)
ln Market(-1)
Constant
Observations
R-Squared

ln (Compensation)
Jensen-Murphy-Wruck index Frydman-Saks index
1.344
1.029

(3.14)
(4.12)
0.579
0.898

(3.70)
(5.27)
0.797
0.775
(4.89)
(3.52)
0.301
0.164
1.15
(1.75)
44
44
0.37
0.43

Explanation: OLS estimates, absolute value of t statistics in parentheses. We estimate:

t (ln wt ) =
b t ln S,t + b ln wt1 + c ln S,t1

which gives a consistent estimate of . Jensen Murphy and Wrucks index is based on the data
of Jensen Murphy and Wruck (2004). Their sample encompasses all CEOs included in the S&P
500, using data from Forbes and ExecuComp. CEO total pay includes cash pay, restricted stock,
payouts from long-term pay programs and the value of stock options granted, using from 1992 on
ExecuComps modified Black-Scholes approach. Compensation prior to 1978 excludes option grants,
and is computed between 1978 and 1991 using the amounts realized from exercising stock options.
The Frydman-Saks index is based on Frydman and Saks (2005). Total Compensation is the

sum of salaries, bonuses, long-term incentive payments, and the Black-Sholes value of options
granted. The data are based on the three highest-paid ocers in the largest 50 firms in
1940, 1960 and 1990. Size data for year t are based on the closing price of the previous
fiscal year. The firm size variable is the mean of the biggest 500 firm asset market values in
Compustat (the market value of equity plus the book value of debt). The formula we use
is mktcap=(data199*abs(data25)+data6-data60-data74). Quantities are deflated using the
Bureau of Economic Analysis GDP deflator.

45

Table 2: Panel evidence: CEO pay, own firm size, and reference firm size

ln(Market cap)

ln(Market cap of firm #250)

.37
(18.28)
(24.20)
.72
(13.60)
(10.70)

GIM governance index

Industry Fixed Eects

Firm Fixed Eects
Observations
R-squared

NO
NO
7661
0.22

ln(total compensation)
Top 1000
.37
.38
.26
(18.84) (16.59) (4.60)
(25.13) (29.94) (6.14)
.66
.68
.78
(12.22) (11.37) (14.97)
(10.06) (10.84) (9.71)
0.019
(1.80)
(6.82)
YES
YES
NO
NO
NO
YES
7661
6257
7661
0.29
0.32
0.60

.38
(10.41)
(19.99)
.74
(8.52)
(8.02)

Top
.33
(9.21)
(17.09)
.73
(8.34)
(8.09)

NO
NO
4002
0.20

YES
NO
4002
0.28

500
.34
(8.82)
(13.73)
.74
(7.68)
(9.09)
0.020
(1.22)
(2.86)
YES
NO
3415
0.3

Explanation: We use Compustat to retrieve firm size information, we select each year the
top n (n = 500, 1000) largest firms (in term of total market firm value, i.e. debt plus equity).
The formula we use for total firm value is (data199*abs(data25)+data6-data60-data74). We
then merge with ExecuComp data (1992-2004) and use the total compensation variable,
TDC1, which includes salary, bonus, restricted stock granted and Black-Scholes value of
stock-options granted. All nominal quantities are converted in 2000 dollars using the GDP
deflator of the Bureau of Economic Analysis. The industries are the Fama French (1997) 48
sectors. The GIM governance index is the firm-level average of the Gompers Ishii Metrick
(2003) measure of shareholder rights and takeover defenses over 1992-2004 at year t 1. A
high GIM means poor corporate governance. The standard deviation of the GIM index is
2.6 for the top 1000 firms. We regress the log of total compensation of the CEO in year t
on the log of the firm value (debt plus equity) in year t 1, and the log of the 250th firm
market value in year t 1. Absolute value of t-statistics in parentheses. We report t-statistics
clustered at the firm level (first line) and at the year level (second line).

46

.24
(3.16)
(4.13)
.84
(10.18)
(8.13)

NO
YES
4002
.62

Table 3: CEO pay and typical firm size across countries

ln(total compensation)
ln(median net income)

0.38
(3.7)

ln(pop)

0.41
(4.2)
-0.16
(1.76)

ln(gdp/capita)

0.36
(3.8)

0.12
(1.8)

Social Norm
Observations
R-squared

0.36
(3.1)

17
0.48

17
0.57

17
0.58

-0.018
(1.5)
17
0.52

Explanation: OLS estimates, absolute value of t statistics in parentheses. Compensation information

comes from Towers and Perrin data for 2000. We regress the log of CEO total compensation before
tax in 1996 on the log of a country specific firm size measure. The firm size measure is based on 2001
Compustat Global data. We use the mean size for each country top 50 firms where size is proxied as
net income (data32). The compensation variable is in U.S. dollars, and the size data is converted in
U.S. dollars using the Compustat Global Currency data. The Social Norm variable is based on the
World Value Surveys E035 question in wave 2000, which gives the mean country sentiment toward
the statement We need larger income dierences as incentives for individual eort. Its standard
deviation is 10.4.

47