One distinct feature of the rise in income inequality over recent decades is the surging incomes of the working rich, particularly the pay of a class of top managers. A popular view stresses the role of performance-related pay in generating this feature.
According to this view, the pay of many top managers is high-powered – with incentives tied to firm performance – while the pay of most other workers is low-powered – a flat wage invariant with firm performance. In good times, the managerial pay is boosted by firm profits, while in bad times, top managers are barely punished because of limited liability. Such an incentive structure unduly rewards the managerial class.
This view has been criticised on the grounds of lacking theoretical foundation and being ad hoc. What determines the emergence of such an incentive structure? To what extent does it apply to the entire managerial class? And how does it change over time?
A study published in the December 2017 issue of the Economic Journal answers these questions by proposing a theory of sorting that links talent, pay-performance sensitivity and pay levels. The analysis by Yanhui Wu of the University of Southern California produces a sorting pattern that matches empirical observations of occupational characteristics.
Moreover, it generates predictions about the effects of technological progress and market competition on the distributions of wages, pay structure and employment across a wide range of managerial levels. These predictions are consistent with the time-series and cross-industry patterns of wages and employment in the United States during the last two decades.
The central result of the theory is the sorting of individuals – on the basis of managerial ability – into production workers, business owners, managers paid an ability-invariant bonus and managers whose pay varies with ability and firm performance.
A range of individuals with different abilities is rewarded by different incentive structures but receives a similar level of pay. An alignment between incentive structure and pay level occurs only to high-talent managers, who manage large businesses and also share their employers'' profits.
A key prediction of the theory is that an improvement in productivity-enhancing technological progress will result in the shrinkage of small business owners and an expansion of high-talent managers – and an increase in the level of incentives offered to managers.
Another prediction is that product competition also contributes to a highly skewed wage distribution in favour of top talent. This is because stiffer competition triggers production factors to be reallocated from smaller to larger firms. Following this line of reasoning, an economic sector that is subject to more intense import competition should witness greater income inequalities among workers.
The theory is built on two classic ideas in economics, one about firms and one about industrial organisation. At the firm level, the employment features a so-called ''principal-agent'' relationship: firm owners (principals) hire managers (agents) to improve productivity and design incentive contracts to elicit managerial effort that cannot be observed.
The key challenge that firm owners face is that managers are protected by limited liability: when the outcome is undesirable, either because of bad management or because of bad luck, firm owners cannot punish the manager too much. Thus, the manager cares more about good outcomes and much less about bad outcomes, and does not have the right incentives to work for the firm.
In this situation, the best way to align managerial incentives is to sell the firm to the manager at a transaction price that extracts future cash flows. But the manager has to pay the firm upfront with his or her future certain incomes, and such a first-best arrangement is only feasible when the firm is small.
This explains the emergence of small business owners who get small loans to start their businesses. When the firm is too big, ownership transfer is not feasible and managers became employed workers.
The second-best way to mitigate managerial slack is to design a certain form of contingent pay. For a medium-talent manager, the benefit created by managerial effort is not sufficient to induce the firm to share profits with the manager; the optimal incentive structure is a bonus that is independent of firm profitability. By contrast, the effort of a high-talent manager yields sufficiently large surplus that the owner optimally offers a profit-sharing contract.
At the industry level, the new study borrows a framework developed by Nobel laureate Robert Lucas for the study of the size distribution of business firms. Lucas argued that market competition drives resources (capital and labour) to shift from less able managers to more able ones. This provides an answer to questions about how differences in managerial ability, which are likely to be small, can account for enormous differences in pay levels.
''Incentive Contracts and The Allocation of Talent'' by Yanhui Wu is published in the December 2017 issue of the Economic Journal. Yanhui Wu is assistant professor of finance and business economics at the Marshall School of Business, University of Southern California.