Now that Congress seems due to pass this horrible bailout bill, let us reflect a little on one provision that seems to have sweetened the deal: limits to executive compensation. CEO pay has been controversial for a while now, so it is natural to ask whether they are worth it.
This is what Marko Terviö does using an assignment model and data from 1000 publicly traded US firms. First about the assignment model: its idea is to match firms and CEOs with different characteristics. Outcomes depend on the distribution of those characteristics, and as they are in fixed supply, the price of ability does not necessarily reflect marginal productivity.
The market value of a firm is pivotal here, as it is not only dependent on its current characteristics (and CEO), but future ones as well. Also, a firm contains capital that can be transferred to others. The current surplus of a firm is the product of CEO ability, firm size, a growth factor and capital. This may seem oversimplifying, but you needs to keep managerial ability observable by deduction.
Matching this model with Compustat data, the top 1000 CEOs appear to contribute between US$21 and 25 billion in 2004 (about 0.15% of market capitalization), and they have been paid $7.1 billion for it, including option packages. CEOs seem to be of little impact, but still a bargain. But what if all CEOs were replaced with the best one? The surplus gain would be $3.2-3.4 billion, rather modest. The reason is that the best are already matched with the largest firms.