WHY DO AMERICAN EXECUTIVES make so much more than the average worker—as much as 135 times more by the turn of the 21st century? And why did that wage gap expand so much starting in the late 1990s? In part, because some CEOs had the foresight to invest in promising new technologies, according to Carola Frydman and Dimitris Papanikolaou, associate professors of finance at Northwestern University’s Kellogg School of Management in Evanston, Illinois.
In a report posted online by Kellogg Insight, Papanikolaou says, “It is the skill to make the right investment decisions that differentiates a good from a bad executive.”
Using a mathematical model, the two researchers showed how CEO compensation could change based on investments in new tech and how technological innovation could explain about half of all fluctuations in the ratio of executive-to-worker compensation. In the model, executives get a chance to invest in new technologies as these innovations randomly appear. By doing so, executives can increase their companies’ returns on certain projects; those who invest well earn higher paychecks.
Frydman and Papanikolaou used historical data on worker pay and firm output to gauge how well their model matched real-world results. They determined how much value innovation added to a firm by measuring how much a firm’s stock market value increased when it issued a new patent. While the model predicted increased pay disparities that began in the 1980s, it was less successful tracking the levels of disparity that existed in the 1950s and ’60s.
“What that’s telling us is, there were other factors—that it wasn’t all about technological innovation,” says Frydman. Factors such as unionization might have slowed the rise of executive pay in the early half of the 20th century, as Frydman noted in an earlier study.
Nonetheless, their research shows that 63 percent of the average executive’s pay can be traced to finding new investment opportunities. The authors believe this finding will offer more insights to those tracking trends in high executive compensation.
“In Search of Ideas: Technological Innovation and Executive Pay Inequality” is forthcoming in the Journal of Financial Economics.