Since the 1980s, managerial pay has sharply risen, a pattern similar to the evolution of market power. Given these similar trends, researchers have asked to what extent market power affects managerial pay.
The main problem in addressing this question is that firms with market power tend to be larger, and at the same time, it is predominantly large superstar firms that exert market power. Therefore, since market power and firm size correlate, it is a serious challenge to tease out the role of each in determining managers’ pay. In the BSE Working Paper 1340, “Are Managers Paid for Market Power?”, Renjie Bao, Jan De Loecker, and Jan Eeckhout deal with this problem by building and estimating a structural model that decomposes the origins of manager pay into those that are due to market power and those due to firm size.
The Rising Trends
In the last decades, there has been a dramatic increase in inequality, mainly driven by an increase in top incomes. Among the top income earners, many of them are managers. Therefore, understanding the rise in manager pay is crucial to understanding a part of the rise in inequality. At the same time, recent research has documented that there has been a rise in market power, an evolution that coincides remarkably with the rise in manager pay, as shown in Figure 1. Indeed, from 1994 to 2019, the average CEO salary more than doubled from $3.34 million to $6.96 million, while the average markup also increased. It is then natural to ask whether managers are paid for market power.
Firm Size Matters
Managers are different than production and service workers. Successful managers make other workers more productive and raise the firm’s productivity. Clearly, this makes firms pay a premium to hire those managers. Also, when firms become larger in size and more profitable, the positive effect of the manager becomes more valuable, given that every single decision now has far-reaching implications. Since firms compete for managers in the labor market, this competition leads to higher pay for managers in large firms.
However, it is still an open question what determines the size and productivity of the firm, and in this work, the authors shed light on this question by studying the role of market power.
A Story of Top Managers
After building and estimating a large economy of many oligopolistic markets where heterogeneous firms compete for managers with heterogeneous abilities, the authors are able to quantify the effect of market power. Using data on executive compensation from Compustat between 1994 and 2019, the authors found that, on average, 45.8% of managers’ pay is due to market power, and the remaining is a consequence of firm size. Not only this, but over that period, 57.8% of the pay growth is due to market power. Most striking is the fact that there is a lot of heterogeneity among managers depending on their ability. For top managers, 80.3% of their pay is due to market power.
The logic behind the model is that a manager with a higher ability will make a firm more productive, and this will increase its profit and market power. The effect is higher for firms that are already big before the hiring, and therefore those firms already had more market power. This implies that firms raise the pay of high-ability managers with high market power biding against each other. Overall, the best managers will contribute to raising profit and market power but will provide little additional value to the economy.
The authors identify that under competition with market power, the most productive firm gets higher rents than the less productive. Since manager ability is complementary to firm productivity, most productive firms can widen the gap even more by hiring highly skilled managers. As a consequence, firms will increase their market power. On the other hand, low-productive firms that have low market power have very little to gain from hiring a superstar manager. This implies that top managers are disproportionately hired by firms with market power and are rewarded for it.
Video: Market Power and Secular Macroeconomic Trends
This paper ties into a European Research Council (ERC) Advanced Grant awarded to Barcelona School of Economics Research Professor Jan Eeckhout. In the short video below, Professor Eeckhout talks about the relationship between the rise of market power and the profound macroeconomic changes of the past 40 years: