Executive Pay, Talent and Firm Size: Why has CEO Pay Grown so Much?

We exposit an integrated agency model of multi-period career concerns and labor market equilibrium with managerial reservation utility levels, and thus pay levels, determined endogenously for firms of different sizes. Based on observations from a long time-series of S&P 1500 companies, we estimate the stochastic production function describing the incremental wealth created by the manager as a function of “effort”, latent raw “talent”, idiosyncratic firm risk (asset volatility) and the opening value of assets employed. We show that CEO talent affects the marginal productivity of the firm at approximately twice the rate as effort. Since asset volatility is also more subject to scale effects than effort, risk per marginal product of effort is higher in larger firms. Due to the cost of compensating managers for risk, pay-performance sensitivity optimally declines with size. Furthermore, our talent estimates explain much of the increments to real CEO pay levels and income over recent decades as a response to increases in talent and as compensation for higher risk borne by executives, with firm size growth playing a negligible role. We also identify the most talented CEOs who earned enterprise returns 17 times higher than the CEOs of the largest firms.