An old friend, the head of the elementary department at an independent boys’ school, used to run a philosophy club for boys aged six and seven. One day the teacher said to them: “Imagine we are a pirate band and we have just found a huge cache of treasure. I am the captain, so I get half the treasure. You have to decide how you are going to allocate the rest.”
The boys discussed whether to share their half proportionately to their grades in class or how good they were at football, but eventually they decided to split it equally – the egalitarian option. After this lesson in distributive justice, all seemed well. But then one little boy asked: “Please Mrs Taylor, why do you get half the treasure?”
This question – is it fair that some people appear to obtain a disproportionate share of income and wealth? – has become one of the defining issues of our age. In the past year – as we have been hit by the cost of living crisis, inflation has accelerated and real terms wages have fallen – average pay for FTSE 100 chief executives has increased by 23%, according to research by PwC.
Given the pressures facing us all this year, it’s hard not to be troubled by these figures. But what do the business executives themselves think? Are they the greedy, self-interested fat cats of popular culture, or do they share society’s concerns about large pay differentials and high levels of inequality? If they do have concerns, why has senior executive pay increased so dramatically in the UK and the US during the past 30 years?
My particular research interest is senior executive pay, and a few years ago I decided to investigate this question with my colleague Dr Susanne Burri at the London School of Economics. We asked 1,000 business executives around the world to think themselves into what the philosopher John Rawls called the “original position”, in which no one knows their place in society, their social status, nor their fortune in terms of their share of natural assets, their intelligence, or their physical strength.
Then we asked the executives to express how they felt about six different principles of distributive justice, including desert (some people deserve higher rewards because of their contribution) and sufficiency (everyone is entitled to have enough to lead a dignified life). Did they agree that communities and companies in which each of these principles was embedded would be a just society?
It was evident from the results of our study that many executives take distributive justice very seriously. They engaged with the survey process, telling us about the amount of time they had taken to digest the questions and reflect on their answers. They agreed or strongly agreed with more principles of justice than they disavowed. The narrative comments that many of them provided were consistent with a serious ethical perspective on pay and inequality. We concluded that senior executives are not in the main the self-interested egoists of popular culture – some are, but most are not. Instead, they are the most fortunate beneficiaries of a market failure.
Economists have known for a long time that labour markets are different from other commodity markets. This is particularly true of the market for the people the French economist Thomas Piketty described in his book Capital in the Twenty-first Century as “super-managers”. An efficient market requires many buyers and sellers, homogeneous products or at least good substitutes, free market entry and exit, plentiful information and little economic friction. The problem with the market for top executives is that practically none of these conditions hold good.
Because executive labour markets fail to provide effective price signals, the non-executive directors whose job is to determine the remuneration of top managers face what economists call the prisoners’ dilemma as they seek alternative ways of rationally determining top pay. As a result, they pay over the odds, in the hope that they may attract one of the better super-managers and avoid the worst.
Offering higher pay becomes the dominant strategy, even though by doing so companies will generally be no better off than if they all paid more moderate salaries. In more typical labour markets, with greater numbers of participants and more ready substitutes, the same pressure to pay over the odds doesn’t arise.
You may well ask why executives keep taking the money if so many of them appear to take distributive justice seriously? Research on the psychology of incentives has shown that when it comes to comparisons of income we are only interested in a narrowly defined reference group. We care about how those close to us in comparable jobs are doing much more than those in very different social situations. It’s the natural way in which we evaluate what we are worth. In this respect, super-managers are no different from the rest of us.
Investors, companies and executives need to recognise inflation in top pay for what it is – an important ethical problem. When it comes to senior executive rewards, for too long companies have behaved as though they are in the equivalent of an arms race. It is a mad, bad system, and it needs to change if executive pay is to be brought under control.
Alexander Pepper is emeritus professor of management practice at the London School of Economics, and the author of If You’re So Ethical, Why Are You So Highly Paid?
