The Folly of Setting Pay Limits

In an ideal world, I would like to think that every aspect of the labor market is efficient and competitive, and that people get paid according to the value that they provide to the firm for which they are employed. In most cases, I believe this is a good approximation to the truth. However, when it comes to the instance of CEO pay for very large firms, I find this hypothesis to require a stretch of the imagination.

In an ideal world, CEOs would be looking out for the long-term interests of the shareholders. This means maximizing long-run profits. However, what CEOs are actually interested in is how well they personally do. The job of boardrooms is to design incentive schemes that align the personal interests of the CEO with the interests of the stock holders. I would say that in many well-publicized instances, they have failed. This is an example of a problem in economics called the principal-agent problem.

There may indeed be effective policy reforms which could mitigate the principal-agent problem in the market for CEOs. Setting arbitrary pay limits, however, is no solution. This very clear and intelligent article in the Financial Times explains why.