Forum for Science, Industry and Business

Sponsored by:     3M 
Search our Site:

 

New theory on fairness in economics targets CEO pay

05.11.2009
Chief executives in 35 of the top Fortune 500 companies were overpaid by about 129 times their "ideal salaries" in 2008, according to a new type of theoretical analysis proposed by a Purdue University researcher to determine fair CEO compensation.

One of the most pressing economic and corporate governance issues of the day is how to determine fair pay packages for CEOs," said Venkat Venkatasubramanian, a professor of chemical engineering. "The proposed theory allows us to compute what the fair pay is for a CEO, including bonuses and stock options, under ideal conditions."

The ratio of CEO pay to the lowest employee salary has gone up from about 40-to-1 in the 1970s to as high as 344-to-1 in recent years in the United States. However, the ratio has remained around 20-to-1 in Europe and 11-to-1 in Japan, according to available data, he said.

Using the new analysis method, Venkatasubramanian estimated that the 2008 salaries of the top 35 CEOs in the United States were about 129 times their ideal fair salaries. CEOs in the Standard & Poor's 500 averaged about 50 times their fair pay, raising questions about the efficiency of the free market to properly determine fair CEO pay, he said.

"You might ask why a chemical engineer is concerned with economics and CEO salaries," Venkatasubramanian said. "Well, it turns out that the same concepts and mathematics used to solve problems in statistical thermodynamics and information theory also can be applied to economic issues, such as the determination of fair CEO salaries."

Findings appeared Tuesday (Nov. 3) in the online open-access journal Entropy. The paper, "What is Fair Pay for Executives? An Information Theoretic Analysis of Wage Distributions," is available for free downloads from the Entropy site at http://www.mdpi.com/1099-4300/11/4/766

A key idea in his theory is the economic interpretation of the concept of entropy.

"There have been many attempts to find a suitable interpretation of entropy for economic systems without much success," Venkatasubramanian said. "Just as entropy is a measure of disorder in thermodynamics and uncertainty in information theory, what would entropy mean in economics?"

Venkatasubramanian identified entropy as a measure of "fairness" in economic systems, revealing a connection between statistical thermodynamics, information theory and economics.

"As we all know, fairness is a fundamental economic principle that lies at the foundation of the free and efficient market system," he said. "It is so vital to the proper functioning of the markets that we have regulations and watchdog agencies that break up and punish unfair practices such as monopolies, collusion and insider trading. Thus, it is eminently reasonable, indeed reassuring, to find that maximizing fairness, or maximizing entropy, is the condition for achieving economic equilibrium."

Using the new theory, the ideal pay distribution is determined to be "lognormal," a particular way of characterizing data patterns in probability and statistics.

"This is the economic equivalent of the Boltzmann distribution for ideal gases, which describes how the gas molecules are distributed at various energy levels," Venkatasubramanian said. "One may view our result as an 'economic law' in the statistical thermodynamics sense. The free market will 'discover' and obey this economic law if allowed to function freely and efficiently without collusion-like practices or other unfair interferences."

The publication comes at a time when Congress is grappling with the issue. The Federal Reserve announced a plan on Oct. 22 to eliminate excessive pay packages that might encourage bankers to take reckless risks. The Obama administration pay czar, Kenneth R. Feinberg, has announced plans to reduce executive pay at companies that received the most federal bailout money, slashing the base salaries of those top executives and setting top pay at $200,000 for AIG executives in the financial products division.

Until now, however, there has been no scientific way of determining executive pay.

"We now have a rational quantitative basis for setting the fair base pay scales for the top management, and any added incentive pay package might then be linked to measureable and meaningful performance metrics that promote long-term survival and growth for the organization," Venkatasubramanian said.

Fair pay for an average S&P 500 CEO should ideally be in the range of 8 to 16 times the lowest employee salary, Venkatasubramanian said.

"It's interesting to note that Warren Buffett, CEO of Berkshire Hathaway and an outspoken critic of executive pay excesses, drew an annual salary of $200,000 in 2008," Venkatasubramanian said. "This makes his pay ratio 8-to-1, assuming a minimum employee salary of $25,000 per year, which fits the ideal benchmark estimate for fair CEO pay almost exactly. Mr. Buffett's instincts about fairness seem to be amazingly accurate. The top pay set by Mr. Feinberg for the AIG executives is almost exactly the amount recommended by the new theory."

As a contrast to the United States, average CEO pay ratios were about 11-to-1 in Japan, 15-to-1 in France, 20-to-1 in Canada, and 22-to-1 in Britain in 2006.

"These ratios are not that far off, when compared to U.S. ratios, from the ideal benchmark estimates from my theory," Venkatasubramanian said. "Even in the United States, the CEO pay ratios in the 1960s and 1970s were much more reasonable and in general agreement with the ideal values. So the executive pay excesses appear to be a recent phenomenon. This appears to be another valuation bubble - the CEO valuation bubble - much like the ones we have witnessed in stocks, real estate, commodities, etc."

William A. Masters, professor and associate head of Purdue's Department of Agricultural Economics, said, "This paper tackles an important problem in a new way. Venkat is a brilliant engineer who sees patterns that others miss. It's wonderful to see this kind of cross-disciplinary investigation, broadening the range of ideas and mathematical tools being applied to crucial issues like CEO pay."

Writer: Emil Venere, 765-494-4709, venere@purdue.edu
Source: Venkat Venkatasubramanian, 765-494 0734, venkat@ecn.purdue.edu

Emil Venere | EurekAlert!
Further information:
http://www.purdue.edu

More articles from Business and Finance:

nachricht How Strong Brands Translate into Money
15.11.2016 | Kühne Logistics University - Wissenschaftliche Hochschule für Logistik und Unternehmensführung

nachricht Demographic change depresses tax revenues
04.11.2016 | Fraunhofer-Institut für Angewandte Informationstechnik FIT

All articles from Business and Finance >>>

The most recent press releases about innovation >>>

Die letzten 5 Focus-News des innovations-reports im Überblick:

Im Focus: Novel silicon etching technique crafts 3-D gradient refractive index micro-optics

A multi-institutional research collaboration has created a novel approach for fabricating three-dimensional micro-optics through the shape-defined formation of porous silicon (PSi), with broad impacts in integrated optoelectronics, imaging, and photovoltaics.

Working with colleagues at Stanford and The Dow Chemical Company, researchers at the University of Illinois at Urbana-Champaign fabricated 3-D birefringent...

Im Focus: Quantum Particles Form Droplets

In experiments with magnetic atoms conducted at extremely low temperatures, scientists have demonstrated a unique phase of matter: The atoms form a new type of quantum liquid or quantum droplet state. These so called quantum droplets may preserve their form in absence of external confinement because of quantum effects. The joint team of experimental physicists from Innsbruck and theoretical physicists from Hannover report on their findings in the journal Physical Review X.

“Our Quantum droplets are in the gas phase but they still drop like a rock,” explains experimental physicist Francesca Ferlaino when talking about the...

Im Focus: MADMAX: Max Planck Institute for Physics takes up axion research

The Max Planck Institute for Physics (MPP) is opening up a new research field. A workshop from November 21 - 22, 2016 will mark the start of activities for an innovative axion experiment. Axions are still only purely hypothetical particles. Their detection could solve two fundamental problems in particle physics: What dark matter consists of and why it has not yet been possible to directly observe a CP violation for the strong interaction.

The “MADMAX” project is the MPP’s commitment to axion research. Axions are so far only a theoretical prediction and are difficult to detect: on the one hand,...

Im Focus: Molecules change shape when wet

Broadband rotational spectroscopy unravels structural reshaping of isolated molecules in the gas phase to accommodate water

In two recent publications in the Journal of Chemical Physics and in the Journal of Physical Chemistry Letters, researchers around Melanie Schnell from the Max...

Im Focus: Fraunhofer ISE Develops Highly Compact, High Frequency DC/DC Converter for Aviation

The efficiency of power electronic systems is not solely dependent on electrical efficiency but also on weight, for example, in mobile systems. When the weight of relevant components and devices in airplanes, for instance, is reduced, fuel savings can be achieved and correspondingly greenhouse gas emissions decreased. New materials and components based on gallium nitride (GaN) can help to reduce weight and increase the efficiency. With these new materials, power electronic switches can be operated at higher switching frequency, resulting in higher power density and lower material costs.

Researchers at the Fraunhofer Institute for Solar Energy Systems ISE together with partners have investigated how these materials can be used to make power...

All Focus news of the innovation-report >>>

Anzeige

Anzeige

Event News

ICTM Conference 2017: Production technology for turbomachine manufacturing of the future

16.11.2016 | Event News

Innovation Day Laser Technology – Laser Additive Manufacturing

01.11.2016 | Event News

#IC2S2: When Social Science meets Computer Science - GESIS will host the IC2S2 conference 2017

14.10.2016 | Event News

 
Latest News

UTSA study describes new minimally invasive device to treat cancer and other illnesses

02.12.2016 | Medical Engineering

Plasma-zapping process could yield trans fat-free soybean oil product

02.12.2016 | Agricultural and Forestry Science

What do Netflix, Google and planetary systems have in common?

02.12.2016 | Physics and Astronomy

VideoLinks
B2B-VideoLinks
More VideoLinks >>>