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A Thermodynamic Take on Executive Pay

A REVIEW: Venkat Venkatasubramanian, What is Fair Pay for Executives? An Information Theoretic Analysis of Wage Distributions. Published in Entropy, an international scientific journal, November 2009.

We’ve known the basic facts about CEO pay for quite some time now. U.S. top executives today take home, on average, over 300 times what their workers earn. Until the 1980s, these execs seldom made over 40 times worker pay.

But what should CEOs make? In an ideal world, exactly how much pay should go to the top execs of major enterprises that employ many thousands of people?

Economists, by and large, don’t bother with questions like these. They assume the “free market” will work out an appropriate answer.

But the “free market,” at the executive level, isn’t working too well. Corporate boards determine executive pay, not the “laws” of supply and demand. And these boards, as Purdue University chemical engineer Venkat Venkatasubramanian points out in this provocative new analysis [1] of executive compensation, have no “rational quantitative framework for evaluating a CEO’s value.”

Venkat VenkatasubramanianWhat’s a chemical engineer doing writing about CEO pay?

“The same concepts and mathematics used to solve problems in statistical thermodynamics and information theory,” Venkatasubramanian explains [2], “can be applied to economic issues, such as the determination of fair CEO salaries.”

His new paper does that applying. Or, to be more specific, this Purdue engineer applies to executive pay “the Principle of Maximum Entropy,” along the way drawing on concepts from thermodynamics and statistical mechanics, winding up with a framework he calls “statistical teleodynamics.”

If you can follow all that, you’ll really enjoy this new paper. But even if you can’t, this contribution to the scientific journal Entropy has plenty of insights to offer. Venkatasubramanian mixes equations with expositions you don’t have to be an engineer or scientist to follow.

Venkatasubramanian gets his logic train rolling by asking us to imagine two extreme pay scenarios. In one, everyone in an enterprise — from the cleaning crew to the chief executive — gets the exact same reward. In the other, the bulk of the rewards go to the CEO and everyone else gets paid an negligible amount.

Each scenario makes an unsustainable assumption, the first that everyone is contributing in absolutely equal value to enterprise success, the second that only the CEO is contributing real value. No enterprise could long survive with either scenario. The disenchanted would abandon ship “in droves.”

The optimum compensation configuration, Venkatasubramanian observes, must lie “somewhere in between these two extremes.” But where? What would be the “maximally fair assessment of relative value”?

His eventual answer: Fair total compensation for an average S&P 500 CEO should ideally be in the range of eight to sixteen times the lowest employee take-home.

In 2008, the actual pay gap between workers at the bottom and the top 500 CEOs averaged 50 times more than this ideal. Venkatasubramanian also looked at a sampling of 35 of that year’s 50 highest-paid CEOs. They took home 129 times more than his no more than sixteen-to-one ideal ratio.

Venkatasubramanian feels his quantitative framework could be a useful jumping-off point for designing tax policy and corporate governance guidelines.  But how practical would his framework actually be? This practical: Executive pay in Japan and other successful industrial nations already fits within his guideposts — and U.S. executive pay, back in the 1960s, came close to fitting in, too.

signup [3]In other words, as Venkatasubramanian points out, America’s “executive pay excesses appear to be a recent phenomenon.”

And a dangerous one, too. Markets only work in an orderly fashion, this Purdue analyst relates, when “participants feel they have received a maximally fair deal given the constraints.” Our economic systems, he adds, “work best when they have orderly markets.”

“Why then,” his paper asks, “would anyone want to maximize disorder?”

Sam Pizzigati, editor, Too Much