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The Value Creation Gap: Why CEO Pay is So High

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“The rich are getting richer and the poor are getting poorer”: this common refrain is thought by some to explain many of the world’s problems. Recently there has been outrage directed toward high-income individuals. A popular video recently posted to Upworthy graphically depicts the “growing problem” of the gap between the rich and the poor. It notes in particular that many CEOs make 380 times the amount of the average worker. CEOs may work hard, it observes, but how could they be working 380 times harder than these workers?

It may be true that income inequality is increasing, and that CEOs are making more money than they have in the past. But why are CEOs paid so much?

Economically, the income gap is the result of the law of supply and demand. For example, let’s say the Atlas Company needs a new CEO. The board of directors will negotiate the salary with potential CEOs in an attempt to get the highest quality candidate for the best cost; they are willing to offer a high salary because the CEO offers a large value to the company. And if the board did not offer a large enough salary, the highest quality candidates would choose to work at different companies that made a better offer.

There is a short supply of people who qualify to do the job of CEO. Only a small number of people have devoted the energy required to gain the knowledge and develop the skills needed to do the job well. The short supply matters: when there is a short supply of something, the price increases. In a free market, when there is a short supply of talented CEOs, the price for a person to fill this role will rise as well. (In a market that is not fully free, other factors can artificially raise CEO pay.)

A good CEO is a rare find because the job is so difficult. From implementing high-level strategies to managing the overall operations and resources of a company, the CEO’s decisions impact everyone working for the company, its investors, the company’s competitors, the company’s allies, and the entire industry. The skill required is enormous.

As CEO of Apple, Steve Jobs needed to envision the right product, organize and manage the best team to make it. He needed to find, convince, and work with the best companies to help make the vision come true. And he needed to determine how to market the product so that customers would understand its significance. A month before the launch of the iPhone, Jobs realized the plastic screen on the phone scratched easily, and he demanded they develop a glass screen. He orchestrated the hiring of 8,700 engineers to figure out how to cut the glass and then found a factory of workers to cut the glass into millions of screens. They were done in four weeks.

This example is just a snapshot of the type of work a CEO must perform.

Everyone wins in a free economy: the CEO gets the position and the pay check he desires for the work he puts into the company, the board and the employees get a high quality leader that will help the company perform well, and customers get an excellent product.

If you doubt the skill required to be a CEO, consider the woes of companies like Enron, Netflix’s Quikster, Blockbuster, Circuit City, Lehman Brothers, Washington Mutual. Each company failed and its failures were due to the company’s CEOs. Can you say “a lot of pressure?”

If you are wondering why CEOs deserve to receive high salaries and golden parachutes even when they fail, keep in mind that benefits and compensation are often negotiated to convince the candidate to accept the position in the first place. The board must offer a great package in order to attract the best candidates, and the company is under contract to fulfill its promise, even if the CEO fails.

It’s worth noting that CEOs are paid voluntarily, and if anyone takes issue with anything about a company, they can quit the company, not buy the company’s products or invest in it, or, spread word of the perceived issue with the company.

One might think it’s just not right for CEOs to be paid so much more than their employees. CEOs may not work 380 times harder than employees, but they do create a substantially greater amount of value. And it is the CEO who enables the employees to have a job in which their skills can create value in the first place.

It is value creation that properly determines pay, not the degree of effort expended. If I spent three days pushing a giant boulder five miles, I would find this extremely difficult; my muscles would be sore and I would be exhausted. But this does not mean I deserve to be paid a large amount of money for this hard work: I didn’t create anything of value. People who create more value for others, enabling others to live better, deserve to be paid more.

So a CEO’s high salary can indeed be morally justified, because people deserve rewards in proportion to the value they create. There is nothing wrong with the income gap, because there is nothing wrong with the fact that different people create different amounts of value.

The rich may be getting richer, but if they do because they create new value in an economy, it’s hard to believe that the poor get poorer because of it.

 

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