16 October, 2014

The Economist Who Won The Nobel Prize Explained Why CEOs Get Such Gigantic Bonuses

Why are CEOs paid so well?
In part, because they constantly have theopportunity to renegotiate their contracts, which are often heavy on the stock-based bonuses.

The work of Jean Tirole, the newest Nobel Prize winner in economics, helps explain why this is the case.

Contracts Are Not Immutable
A lot of theories of negotiation before Tirole assumed that a contract was immutable once it was signed. But in reality, a contract often can be renegotiated. When both parties know that, it changes the way they approach the original contract.

Take, for example, an executive compensation agreement. Tirole's research with Drew Fudenberg explains that moral hazard is affected in a long-term contractual agreement when there's an option for renegotiation. Specifically, it helps explain why so much of what a CEO gets paid is tied to performance and tied up in things like stock options. The CEO gets what seems like a lot, but knowing that he can ask for more next year makes it important that that compensation is tied to how well the company is doing.

The paper notes that the Tirole-Fundenberg model has two implications for executive compensation. First, "an executive who has made important long-run decisions (project or product choices, investments), will be offered the discretion to choose from a menu of compensation schemes, some offering a fairly certain payment and some offering riskier, performance-related payment." In reality, there's a broad range in what and how executives get paid, but a lot of them choose the high risk, high reward plan.

The second implication is that executive compensation usually doesn't have a lot to do with how the company does when she's gone from the company, although some CEOs do continue to get bonuses after they retire.

For example, giving an executive $10 million per year in stock options that don't vest until next year may seem ludicrous on its face, but it's better than promising him $5 million in cash and watching him walk away after the company crumbles six months in.

Government Defense Contracts
Tyler Cowen writes about the implications Tirole's work has for government deals with monopolistic industries (like defense contractors). Say the government signs a five year contract with a defense contractor. Previous research focused on how the two parties should negotiate the contract assuming that what they agreed to would never been renegotiated.

In reality, three years into the project, the company can (and probably would) come back to the government and say, "The project is harder than expected. We won't be able to finish unless you give us X more money." Given the costs of losing the contract, it might actually be better for the government to just give in to these demands.

Tirole's paper finds that when you factor in this potential issue, it might be better for the government to give in to certain demands in the original contract that it otherwise wouldn't if the contract could never been renegotiated - which helps explain why a lot of government contractors seem to get really sweet deals.

Tirole is an economist at the Toulouse School of Economics. He won the prize, according to the Nobel committee's reasoning, for his work on the overall theory of industrial organization (IO) and regulation.

For a more comprehensive overview of Tirole's work, see Tyler Cowen's excellent roundup and the Nobel committee's summary.