The Nobel in Economics was just awarded to two economists who have figured out how best to do this. Our friends at Marginal Revolution wrote a nice essay summarizing their contributions:
- Use all signals of productivity to better measure performance ("informativeness principle").
- Put greater weights on the best measures (least noisy).
- Use a higher base salary when employees are risk averse (to compensate them for bearing risk).
- Use relative performance metrics ("tournaments") when employees have similar abilities.
- Use absolute performance metrics when employees do not (otherwise, employees with the most ability will easily win the tournament--without working hard).
We can use this analusis to critique executive pay:
...executive pay often violates the informativeness principle. In rewarding the CEO of Ford for example, an obvious piece of information that should used in addition to the price of Ford stock is the price of GM, Toyota and Chrysler stock. If the stock of most of the automaker’s is up then you should reward the CEO of Ford less because most of the gain in Ford is probably due to the economy wide factor rather than to the efforts Ford’s CEO. For the same reasons, if GM, Toyota, and Chrysler are down but Ford is down less then you might give the Ford CEO a large bonus even though Ford’s stock price is down. Oddly, however, performance pay for executives rarely works like a tournament. As a result, CEOs are often paid based on noise.