In Search of Ideas: Technological Innovation and Executive Pay Inequality∗

We develop a general equilibrium model that delivers realistic fluctuations in both the level as well as the dispersion in executive pay as a result of changes in the technology frontier. Our model recognizes that executives add value to the firm not only by participating in production decisions, but also by identifying new investment opportunities. The economic value of these two distinct components of the executive’s job varies with the state of the economy. Improvements in technology that are specific to new vintages of capital raise the skill price of discovering new growth prospects – and thus raise the compensation of executives relative to workers. If most of the dispersion in managerial skill lies in the ability to find new projects, dispersion in executive pay will also rise. Our model delivers testable predictions about the relation between executive pay and growth opportunities that are quantitatively consistent with the data. ∗We thank Francisco Buera, Andrea Eisfeldt, Francois Gourio, Amit Seru and the seminar participants at the FRB Chicago for helpful comments and discussions. Dimitris Papanikolaou thanks Amazon (AWS in Education Grant award), the Zell Center for Risk and the Jerome Kenney Fund for research support. Dispersion in pay between top executives and workers, as well as among executives, has fluctuated considerably over the last century. These large changes over time have sparked a considerable debate among economists and policymakers.1 Advocates of a ‘market-based’ view of executive compensation argue that the level of pay is the efficient outcome from firms competing for scarce managerial talent in the market for executives. In contrast, proponents of a ‘rent-extraction’ view of compensation propose that executive pay is instead the result of weak corporate governance and acquiescent corporate boards that allow executives to (at least partly) set their own pay and extract compensation in excess relative to the value that they add to the firms that they manage. However, most of the current explanations model executive skills (such as managerial talent, or their ability to extract rents) as one-dimensional. Instead, we argue that executives contribute to their firms along multiple dimensions, and importantly, that the marginal value of those skills could change with economic conditions. In this paper, we focus on one important aspect of an executive’s job – the ability to identify new investment opportunities – and show that the interaction of this skill with technological progress can lead to substantial fluctuations in both the level and the dispersion in executive pay. We build a dynamic general equilibrium model with heterogenous firms that employ executives and workers. Executives add value to the firm along two dimensions. First, similar to workers, they provide labor services that are complementary to the firms’ existing assets. However, executives are distinct from workers in that they also participate in the creation of new capital. Specifically, executives have the ability to identify new investment opportunities for the firm. The efficiency of an executive in identifying these opportunities depends on the quality of the match between the firm and the executive. Matching between executives and firms is random, and so the quality of the match is initially unobservable. Over time, as executives make investment decisions, all market participants update their beliefs about the quality of the match from her performance, and those with poor performance are fired. In equilibrium, executives are rewarded for both of their skills, while workers are only rewarded for their efforts in production. Similar to worker compensation, executive pay includes a component that is related to their direct contribution to the production process, which is proportional to aggregate output. But the compensation of executives includes a second component that depends on the marginal return to new investments, which in turn depends on the perceived quality of the match and the bargaining power of executives. Thus, our framework departs from canonical models of executive pay that relate compensation to a single measure of firm size, and allows us to explain why observed levels of pay differ substantially across firms even after controlling for firm size. Our model generates time variation in both the level of executive pay – scaled by either the earnings of the average worker, or by total output – as well as the dispersion in pay among executives. The key mechanism is that the marginal returns of these two skills are neither constant nor comove For instance, starting in August 2015, the Securities and Exchange Commission (SEC) requires all public firms to disclose the ratio of the pay of the CEO to the median compensation of their employees.