Obama's Cap on Executive Pay

By Christopher Espinal

President Obama has capped executive pay at $500,000 for all companies that will accept bailout money. I will outline the economic implications for this price cap.

The market will decide how to value the productive capacity of individuals. The expected or observed productivity of a worker, and the relative scarcity of the subject's skill set,will determine his or her worth to a firm.

To say that the market decides on the best allocation of workers is to imply that the pricing mechanism always clears the market. That also implies that artificial alterations in the pricing mechanism will cause supply and demand of labor productivity to readjust to new levels if a price ceiling is below the market equilibrium.

This is exactly the problem with placing a cap on pay. It will only cap the level of productivity exhibited by the executives – and perhaps cause a reallocation of this high productivity skill set to other industries. One must remember that compensation prices serve as signals of productivity, which also means that lower prices will indicate a need for lower productivity. This will affect the overall productive capacity of a firm – which determines its cost efficiency and thus its profit.

All of these negative effects of caps on executive pay conclude with an increase in the risk of failure for a firm,especially in a time of economic instability. The best way to turn around a failing firm is appoint smart, and therefore pricy, executives; not less experienced individuals with less human capital.

This idea applies even more to firms that need bailout money, although executives with good pay may have less of an incentive to accept money with strings attached.

All in all, better executives will be needed to keep firms alive, but that may require more money than caps on executive pay allow. Regardless of the importance of high productivity, it would be interesting to discover if firms are in this mess primarily because of low productivity executives. However, I would still be skeptical if the government can price their worth.

There is one interesting idea on the other side of the boat. If fewer companies accept this bailout money, because of this radical cap on executive pay, then that may induce firms to act more responsibly given the few non-governmental resources available to them.

Christopher Espinal is an economics student at the University of Chicago. He can be reached at espinalc@uchicago.edu