(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 672

CHAPTER 17 • Markets with Asymmetric Information 647

Unfortunately, the means by which stockholders control managers’ behavior
are limited and imperfect. Corporate takeovers may be motivated by personal
and economic power, for example, instead of economic efficiency. The managerial labor market may also work imperfectly because top managers are frequently
near retirement and have long-term contracts. The problem of limited stockholder
control shows up most dramatically in executive compensation, which has grown
very rapidly over the past several decades. In 2002, a Business Week survey of the
365 largest U.S. companies showed that the average CEO earned $13.1 million in
2000, and executive pay has continued to increase at a double-digit rate. Even more
disturbing is the fact that for the 10 public companies led by the highest-paid CEOs,
there was a negative correlation between CEO pay and company performance.
It is clear that shareholders have been unable to adequately control managers’
behavior. What can be done to address this problem? In theory, the answer is
simple: One must find mechanisms that more closely align the interests of managers and shareholders. In practice, however, this is likely to prove difficult.
Among those suggestions put into effect recently by the Securities and Exchange
Commission, which regulates public companies, are reforms that grant more
authority to independent outside directors. Other possible reforms would
tie executive pay more closely to the long-term performance of the company.

EX AMPLE 17. 5 CEO SALARIES
Washington Mutual, an upstart savings and loan
company, saw incredible growth throughout the
1990s and early 2000s. A housing boom was in full
swing, and the bank, led by CEO Kerry Killinger, was
aggressive in pursuing new mortgages. By 2007,
however, Washington Mutual was in trouble. As the
housing market slumped and home values fell, it
became clear that the bank had a dangerous number
of sub-prime mortgages on its books. By the fall of
2008, Washington Mutual’s assets had been seized

by the FDIC and sold to competitor JP Morgan
Chase at the fire sale price of $1.9 billion to avert
what at the time would have been the largest bank
failure in U.S. history. Less than three weeks before
this sale, Washington Mutual’s board of directors fired
Killinger. Still, he received a severance package totaling over $15.3 million.10 Killinger’s successor, Alan
Fishman, led the bank for just 17 days, but received
$11.6 million in severance pay, in addition to a $7.5
million signing bonus.11 Washington Mutual’s shareholders were wiped out in the sale.

Killinger and Fishman were not the only bankers,
or even the only CEOs, to receive large compensation packages, regardless of their performance and
the health of the companies they led. CEO compensation has increased sharply over the past few
decades. The average annual salary for production
workers in the U.S. went from $18,187 in 1990 to
$32,093 in 2009. But in constant dollar terms, the
2009 average salary was only $19,552 (in 1990 dollars), which represents only a 7.5% increase. At the
same time, the average annual compensation for
CEOs has grown from $2.9 million to $8.5 million, or
about $5.2 million in 1990 dollars.12 In other words,
while production workers have seen a 7.5% increase
in their real wages over the past two decades, real
CEO compensation has risen nearly 80%. Why?
Have top managers become more productive, or are
CEOs simply becoming more effective at extracting
economic rents from their companies? The answer
lies in the principal–agent problem, which is at the
heart of CEO salary determination.

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Source: Bureau of Labor Statistics, Institute for Policy Studies—United for a Fair Economy (2006).
Average CEO pay peaked at $11 million in 2005, only to decrease during the 2007–2009 recession.
After 2009, it began to increase again.