Bargaining with the CEO:
The Case for “Negotiate First, Choose Second”
Michael Dorff * & Russell Korobkin **
Executive compensation is one of the most publicized and divisive issues in corporate
governance. Chief Executive Officers of publicly traded companies, who receive the most
attention in the debate, have seen their pay skyrocket over the last several decades, in nominal
terms, in real terms, in comparison to lower level employees, and in comparison to corporate
profits. 1 Some commentators defend the current pay rates as justified by the value that high quality
executives can bring to an entity’s bottom line. 2 Many others contend that CEO performance does
*
Professor of Law, Southwestern Law School.
**
Richard C. Maxwell Professor of Law, UCLA School of Law. The authors thank Sam Pierce for excellent
research assistance, Ben Nyblade for assistance with the statistical analyses, and workshop participants at
the UCLA and Vanderbilt law schools and the Conference on Empirical Legal Studies (CELS) for helpful
comments and suggestions.
1
See Lucian Bebchuk & Yaniv Grinstein, The Growth of Executive Pay, 21 OXFORD REV. OF ECON. POLICY
283 (2005); Michael B. Dorff, INDISPENSABLE AND OTHER MYTHS: WHY THE CEO PAY EXPERIMENT
FAILED AND HOW TO FIX IT 17-26 (Univ. Cal. Press 2014); Carola Frydman & Dirk Jenter, CEO
Compensation, 2 ANNUAL REV. OF FINANCIAL ECON. 75 (2010); Kevin J. Murphy, Executive
Compensation in ORLEY ASHENFELTER & DAVID CARD, HANDBOOK OF LABOR ECONOMICS, Vol. 3, 2485
(1998); Kevin J. Murphy & Jan Zabojnik, CEO Pay and Appointments: A Market-Based Explanation for
Recent Trends, 94 AMER. ECON. REV. 192 (2004); AFL-CIO, Executive Paywatch: Trends in CEO Pay
(2012), available at www.aflcio.org/Corporate-Watch/CEO-Pay-and-the-99/Trends-in-CEO-Pay; and The
State
of
Working
America:
Executive
Pay,
FIN.
TIMES,
available
at
http://blogs.ft.com/businessblog/files/2009/01/state-of-working-america.pdf.
2
See Iman Anabtawi, Explaining Pay Without Performance: The Tournament Alternative, 54 EMORY L.
J. 1557 (2005); Brian E. Becker & Mark A. Huselid, The Incentive Effects of Tournament Compensation
Systems, 37 ADMINISTRATIVE SCIENCE QUARTERLY 336 (1992); Michael L. Bognanno, Corporate
Tournaments, 19 J. OF LABOR ECONOMICS 290 (2001); Melanie Cao & Rong Wang, Optimal CEO
Compensation with Search: Theory and Empirical Evidence, 68 Journal of Finance 2001 (2013); Yuk Ying
Chang, et. al, CEO Ability, Pay, and Firm Performance, 56 MANAGEMENT SCIENCE 1633 (2010); Alex
Edmans & Xavier Gabaix, Is CEO Pay Really Inefficient? A Survey of New Optimal contracting Theories,
15 EUROPEAN FINANCIAL MANAGEMENT 486 (2009); Antonio Falato, et. al, To Each According to His
Ability? The Returns to CEO Talent (2011), available at http://ssrn.com/abstract=1699384; Xavier Gabaix
& Augustin Landier, Why Has CEO Pay Increased So Much?, 123 QUARTERLY J. OF ECON. 49 (2008);
Luis Garicano & Esteban Rossi-Hansberg, Organization and Inequality in a Knowledge Economy, 71
QUARTERLY JOURNAL OF ECONOMICS 1383 (2006); Benjamin E. Hermalin, Trends in Corporate
Governance, 60 J. OF FINANCE 2351 (2005); Jayant R. Kale et. al, Rank-Order Tournaments and Incentive
Alignment: the Effect on Firm Performance, 64 J. OF FINANCE 1479 (2009); Kin Wai Lee et. al, Executive
Pay Dispersion, Corporate Governance, and Firm Performance, 30 REV. OF QUANTITATIVE FINANCE AND
October 7, 2016 DRAFT – do not copy or cite
not justify either the high absolute amount of current compensation packages or the enormous
increases in the value of those packages over time. 3
We address the issue of the appropriateness of executive compensation from a different
perspective in this article by asking this question: regardless of whether CEOs (or other executives)
create more marginal value for their companies than the cost of their compensation packages, could
those companies pay their CEOs less money without reducing CEO quality, thus retaining more
money for shareholders, for compensating lower level employees, or for investment? The focus
of our attention is a particular feature of how CEO compensation – and the compensation of some
other high level employees -- is often determined, although rarely discussed: the firm first decides
which candidate it prefers, and only then negotiates the amount of compensation with the desired
candidate. 4 This bargaining process, which we call “choose first, negotiate second,” or “C1N2,”
stands in sharp contrast to the way firms hire for most lower-paid positions. For more typical
employment categories, the firm is more likely to advertise a wage or salary when recruiting for
the position, and both the firm and the job applicants share the understanding that the candidate
will work for that amount if hired. 5 We call this approach, “negotiate first, choose second,” or
ACCOUNTING 315 (2008); and Kevin J. Murphy & Jan Zabojnik, Managerial Capital and the Market for
CEOs (2007), available at http://ssrn.com/abstract=984376.
3
See Linda J. Barris, The Overcompensation Problem: A Collective Approach to Controlling CEO Pay,
68 INDIANA L. J. 59 (1992); LUCIAN BEBCHUK & JESSE FRIED, PAY WITHOUT PERFORMANCE: THE
UNFULFILLED PROMISE OF EXECUTIVE COMPENSATION (2004); Lucian Bebchuk, et. al, Managerial Power
and Rent Extraction in the Design of Executive Compensation, 69 U. OF CHICAGO L. REV. 751 (2002); Carl
T. Bogus, Excessive Executive Compensation and the Failure of Corporate Democracy, 41 BUFFALO L.
REV. 1 (1993); DEREK BOK, THE COST OF TALENT: HOW EXECUTIVES AND PROFESSIONALS ARE PAID
AND HOW IT AFFECTS AMERICA (1993); John E. Core, et. al, Corporate Governance, Chief Executive
Compensation, and firm Performance, 51 J. OF FINANCIAL ECONOMICS 372 (1999); GRAEF CRYSTAL, IN
SEARCH OF EXCESS: THE OVERCOMPENSATION OF AMERICAN EXECUTIVES (1992); DORFF, supra note
__; Charles Elson, Executive Overcompensation – A Board-Based Solution, 34 BOSTON COLLEGE L. REV.
937 (1993); Mark J. Loewenstein, Reflections on Executive Compensation and a Modest Proposal for
(Further) Reform, 50 SMU L. REV. 201 (1996); Eric W. Orts, Shirking and Sharking: A Legal Theory of
the Firm, 16 YALE LAW & POLICY REV. 265 (1996); Charles M. Yablon, Bonus Questions – Executive
Compensation in the Era of Pay for Performance, 75 NOTRE DAME L. REV. 271 (1999).
4
FREDERICK W. WACKERLE, THE RIGHT CEO: STRAIGHT TALK ABOUT MAKING TOUGH CEO SELECTION
DECISIONS (2001) (“When a candidate is informed that he is the board’s choice to be CEO successor,
serious negotiation begins.”).
5
See, e.g., Book Keeper/Office Assistant, https://losangeles.craigslist.org/lgb/acc/5201891021.html ($13$16/hour); Account Receivable Representative, https://losangeles.craigslist.org/sfv/acc/5201828706.html
($40,000 annually); Controller, https://losangeles.craigslist.org/sfv/acc/5201639179.html ($80,000$95,000 annually); AP Coordinator, https://losangeles.craigslist.org/wst/acc/5201450367.html ($10$12/hour); Structural Drafting, https://losangeles.craigslist.org/sfv/egr/5201885430.html ($12-$15/hour);
Licensed
Architect_Landscape
Designer__Experienced
Draftsman
(Beverly
Hills),
2
October 7, 2016 DRAFT – do not copy or cite
“N1C2.” The bargaining approaches are actually more like points on opposite ends of a spectrum
than they are truly dichotomous. In intermediate cases, firms might, for example, advertise a
position with a compensation range, suggesting that there will be some but limited post-hiring
negotiation, perhaps based on the candidate’s current salary or level of experience. 6
Our hypothesis is that firms could hire CEOs (and other executives) at lower compensation
levels than they currently pay without reducing the quality of their executive talent by
incorporating elements of the N1C2 approach into their senior level hiring process, rather than
waiting to address compensation until they have identified their preferred candidate. After
describing the current debate over executive compensation, and why the issue we address is
orthogonal to it, we describe the theoretical basis of our hypothesis, the results of an experiment
we conducted to test the hypothesis, and our analysis of the experimental results. We conclude by
suggesting a number of possible explanations for boards’ failure to take advantage of the most
theoretically advantageous negotiating strategy in hiring CEOs.
I. The Conventional Argument about CEO Compensation
There is no dispute over the fact that CEO compensation has drastically increased in the
United States in recent decades. From the 1940s through the mid-1970s, CEO pay at large U.S.
public corporations was generally stable, at about $1.4 million per year in 2015 dollars. 7 In 2014,
https://losangeles.craigslist.org/lac/egr/5201599353.html
($120,000);
Science
Educator,
PT,
https://losangeles.craigslist.org/wst/sci/5200217281.html ($15-$18/hour); Technical Services Manager,
https://losangeles.craigslist.org/lac/sci/5199406513.html ($70,000-$80,000 annually); Sales Manager,
https://losangeles.craigslist.org/lac/bus/5201558936.html ($37,000 plus commission).
6
See, e.g., Chemist, https://losangeles.craigslist.org/sgv/sci/5201336105.html (depends on experience);
Quality Assurance/Regulatory Control, https://losangeles.craigslist.org/sfv/sci/5200183537.html (depends
on experience); Corporate Strategy Associate, https://losangeles.craigslist.org/wst/sci/5199274859.html
(depends on experience); Executive Assistant, https://losangeles.craigslist.org/wst/bus/5201858001.html
(competitive
salary
based
on
experience);
Scheduling
Coordinator,
https://losangeles.craigslist.org/lgb/bus/5201695362.html (depends on experience); Dispatch/Field
Support, https://losangeles.craigslist.org/sfv/bus/5201573423.html (based on qualifications).
7
See Frydman and Jenter, supra note __, table 2 (showing that CEO pay remained stable at around $1
million in year 2000 dollars, which is just under $1.4 million in year 2015 dollars).
3
October 7, 2016 DRAFT – do not copy or cite
the median pay at similar companies was $13.6 million in nominal dollars, 8 and the highest-paid
CEO – David Zaslav of Discovery Communications – earned $156 million. 9
What is subject to considerable dispute is whether ever-more-highly-compensated CEOs
are overpaid. “Rational choice” theorists in law and in economics assume that, if the market
provides CEOs with extremely rich compensation packages, offering such packages must be in the
interests of the firms that employ CEOs. 10 Implicit in this claim is the conjecture that the amount
by which the marginal revenue product of a highly-paid CEO exceeds his or her cost (the “net
marginal revenue product”) is greater than the net marginal revenue product of alternative
candidates for the CEO position. 11 We will call this the “rational choice conjecture.”
Let’s assume that the CEO of Aqua Company (“CEO”) is paid $10 million per year. If the
second best candidate (“SB”) for the Aqua CEO position would be willing to do the job for $1
million, the rational choice conjecture suggests that the CEO’s superior skill set will enable Aqua
to earn expected profits of at least $9 million per year more under CEO’s leadership than under
SB’s leadership. If this were not so, the Aqua board of directors would not have agreed to pay the
CEO that much money.
The conjecture must be correct, of course, if the firms that hire CEOs are perfect optimizers
of shareholder wealth. This is a context in which many observers believe actual practice closely
approximates optimization. 12
The CEO pay negotiation takes place between sophisticated
directors representing the corporation and an intelligent and motivated CEO, with both parties
often represented by consultants. 13 Directors invest significant time and energy into structuring
the CEO’s pay package, knowing that it will receive scrutiny from investors and the press and that
its structure may influence the CEO’s behavior – and through the CEO, perhaps the corporation’s
8
See Joann S. Lublin, How Much the Best-Performing and Worst-Performing CEOs Got Paid, WALL ST.
J., June 25, 2015, available at http://www.wsj.com/articles/how-much-the-best-and-worst-ceos-got-paid1435104565.
9
See David Gelles, For the Highest-Paid CEOs, the Party Goes On, NEW YORK TIMES, May 16, 2015,
available at http://www.nytimes.com/2015/05/17/business/for-the-highest-paid-ceos-the-party-goeson.html
10
See supra note 2.
11
See generally, Randall S. Thomas, Explaining the International CEO Pay Gap: Board Capture or Market
Driven?, 57 VANDERBILT LAW REVIEW 1171 (2004) (justifying higher U.S. pay for CEOs in part by
arguing that U.S. CEOs have a higher marginal revenue product).
12
See DORFF, supra note 1, at 60-90. See also supra note 2.
13
See DORFF, supra note 1, at 28.
4
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success. 14 With sophisticated parties on both sides and high stakes involved, it is unsurprising that
many believe CEO pay to be the product of a rational market. 15
Supporters of this perspective offer a variety of explanations for the sharp rise in CEO pay
over the past few decades that is consistent with the rational choice conjecture. Some scholars
believe that increases in CEO pay mirror an increase in marginal value that a good CEO can
provide. They point out that pay correlates with company size, 16 that CEO pay has increased
alongside the growth of companies, 17 that the emergence of new technologies has created
multiplier effect on CEO value, 18 while the supply of CEO-level talent has remained essentially
flat, resulting in an increase in price paid. 19
Relatedly, some contend that innovations in the
structure of CEO pay, such as the standard use of stock options and other contingent compensation,
has provided better incentives for CEO performance, 20 which also suggests that higher pay has
been accompanied by an increase in value created by CEOs.
14
See Randolph P. Beatty & Edward J. Zajac, Top Management Incentives, Monitoring, and Risk-Bearing:
A Study of Executive Compensation, Ownership, and Board Structure in Initial Public Offerings, 1990
ACAD. OF MGT. PROC. 7 (1990) (proposing that firms achieve optimal managerial behavior by structuring
managerial pay correctly); Kee H. Chung & Stephen W. Pruitt, Executive Ownership, Corporate Value,
and Executive Compensation: A Unifying Framework, 20 J. OF BANKING & FINANCE 1135 (1996)
(Executive stock ownership may induce executives to act in shareholders’ best interests); Anne T. Coughlan
& Ronald M. Schmidt, Executive Compensation, Management Turnover, and Firm Performance: An
Empirical Investigation, 7 J. OF ACCOUNTING & ECON. 43 (1985) (finding that boards set executive
compensation to align executives’ interests with those of shareholders); John R. Deckop, et. al, The Effects
of CEO Pay Structure on Corporate Social Performance, 32 J. OF MANAGEMENT 329 (2006) (analyzing
optimal design of CEO pay to improve corporate social performance and thereby improve corporate fiscal
performance); Wm. Gerard Sanders, Behavioral Responses of CEOs to Stock Ownership and Stock Option
Pay, 44 ACAD. OF MANAGEMENT J. 477 (2001) (stock ownership and option pay had opposite effects on
executives’ tendency to acquire or divest assets).
15
See supra, note 2.
16
See Gabaix & Landier (2008), supra note 2.
17
Id.
18
See Garicano & Rossi-Hansberg, supra note 2.
19
See Mariassunta Giannetti, Serial CEO Incentives and the Structure of Managerial Contracts, 20 J. OF
FINANCIAL INTERMEDIATION 633 (2011) (arguing that pay structure is in part designed to encourage
executives to acquire firm-specific skills); Murphy & Zabojnik, supra note 2; and Kevin J. Murphy & Jan
Zabojnik, CEO Pay and Turnover: A Market Based Explanation for Recent Trends, 94 AMERICAN
ECONOMIC REV. 192 (2004).
20
See Frederick L. Bereskin & Po-Hsuan Hsu, New Dogs New Tricks: CEO Turnover, CEO-Related
Factors, and Innovation Performance (2011), http://ssrn.com/abstract=1684329; Ingolf Dittmann & KoChia Yu, How Important are Risk-Taking Incentives in Executive Compensation? (2015),
http://ssrn.com/abstract=1176192; Joel F. Houston & Christopher James, CEO Compensation and Bank
Risk: Is Compensation in Banking Structured to Promote Risk Taking?, 36 J. OF MONETARY ECONOMICS
5
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Other justifications assert indirect benefits from stratospheric executive compensation. A
company might signal its high quality by paying its executives similarly to companies it aspires to
be like. 21 High-quality companies might respond by trying to distinguish themselves by raising
their CEO’s pay further, producing a ratcheting effect. “Tournament theory” 22 hypothesizes that
firms offer excessive CEO pay as part of a strategy to motivate lower-level executives to increase
their productivity by increasing the “prize” for eventually obtaining the top executive position. 23
Although there are many possible explanations for why high and increasing levels of CEO
pay may be justified by the marginal value produced by that pay, alternative explanations suggest
that CEOs are often paid more than their marginal product. The directors who are primarily
responsible for hiring and compensating CEOs may be imperfectly rational in their reliance on
common practice to determine the best compensation structures to employ or in looking to the
amounts paid to other CEOs at comparable companies to evaluate the appropriate amount of pay. 24
Directors may have trouble predicting a CEO’s future marginal revenue product if the tools they
405 (1996); Michael C. Jensen & Kevin J. Murphy, CEO Incentives: It’s Not How Much You Pay, But
How, 3 HARVARD BUSINESS REVIEW 138 (1990); and Josh Lerner & Julie Wulf, Innovation and Incentives:
Evidence from Corporate R&D, 89 REV. OF ECONOMICS AND STATISTICS 634 (2007).
21
See Rachel M. Hayes & Scott Schaefer, CEO Pay and the Lake Wobegon Effect, 94 J. OF FINANCIAL
ECONOMICS 280 (2009).
22
See Edward Lazear & Sherwin Rosen, Rank-Order Tournaments as Optimum Labor Contracts, 89 J. OF
POLITICAL ECONOMY 841 (1981).
23
See id. See also Anabtawi, supra note 2; Michael L. Bognanno, Corporate Tournaments, 19 J. OF LABOR
ECONOMICS 290 (2001); Jing Chen, et. al, Managerial Power Theory, Tournament Theory, and Executive
Pay in China, 17 J. OF CORP. FIN. 1176 (2011); Martin J. Conyon, et. al, Corporate Tournaments and
Executive Compensation: Evidence from the UK, 22 STRATEGIC MANAGEMENT J. 805 (2001) (finding
some evidence of the use of tournaments but also finding that tournaments do not affect corporate
performance); Brian G. M. Main et. al, Top Executive Pay: Tournament or Teamwork?, 11 J. OF LABOR
ECONOMICS 606 (1993); but see Charles A. O’Reilly III et. al, CEO Compensation as Tournament and
Social Comparison: A Tale of Two Theories, 33 ADMINISTRATIVE SCIENCE QUARTERLY 257 (1988)
(finding no empirical support for tournament theory).
24
Relying on common practice without sufficient private information about the effectiveness of the
traditional compensation methods may produce a social cascade in which companies ignore whatever
private information and instead assume the publicly expressed preferences of other firms represents superior
data. See Lisa R. Anderson & Charles A. Holt, Classroom Games: Information Cascades, 10 J. OF
ECONOMIC PERSPECTIVES 187 (1996) (experimentally demonstrating social cascades); Lisa R. Anderson
& Charles A. Holt, Information Cascades in the Laboratory, 87 AMERICAN ECONOMIC REVIEW 847 (1997)
(same); Abhijit V. Banerjee, A Simple Model of Herd Behavior, 108 QUARTERLY JOURNAL OF ECONOMICS
797 (1992) (explaining social cascades); Sushil Bikhchandani, et. al, Learning From the Behavior of
Others: Conformity, Fads, and Informational Cascades, 12 J. OF ECONOMIC PERSPECTIVES 151 (1998)
(same); DORFF, supra note 1, at 190-197 (applying social cascades to CEO pay); and Cass R. Sunstein,
Deliberative Trouble? Why Groups Go to Extremes, 110 YALE L. J. 71 (2000) (explaining social cascades).
6
October 7, 2016 DRAFT – do not copy or cite
have to measure a CEO’s value are poor or if the connection between the CEO’s conduct and the
company’s success is mediated by numerous factors beyond the CEO’s control. 25 Directors may
face conflicts of interest if CEOs have influence over which directors retain their desirable
positions on the board, leading those directors to overpay CEOs as a way of increasing the value
of their own sinecures. 26 The regulatory environment -- particularly tax and accounting rules –
may encourage boards to use inefficient pay structures, such as stock options. 27
Whether the rational choice conjecture is correct and corporate profits more than make up
for high levels of executive compensation is correct is ultimately an empirical question. We have
a view on this question, 28 but the question we explore in this paper is orthogonal to the usual debate
over whether CEO pay costs more than the value it produces.
II. The “Bargaining Process” Hypothesis
Our purpose is to advance a hypothesis that does not rely on a particular view of the
dominant debate concerning CEO compensation. We contend that firms could pay CEOs less than
they do without reducing shareholding wealth, even if it is true that CEOs provide marginal firm
value that is at least equivalent to their marginal compensation. Moreover, we believe that they
could reduce executive pay by implementing a simple type of process change in the way they
negotiate compensation: rather than using the dominant C1N2 process, firms should employ a
N1C2 process. That is, at some point in the selection process by which the pool of candidates is
winnowed from a large group to one, the firm should require each candidate to reach agreement
on a compensation package that he will receive if the firm selects him for the position. We call our
25
Directors’ primary tools in predicting a candidate’s future success as CEO is the candidate’s track record
in other positions (and perhaps other companies) and the interview process. Neither is especially effective
in predicting a CEO’s future success, but psychological phenomena such as the illusion of validity, the
illusion of control, groupthink, and social cascades can make these tools seem more predictive than they
are. See DORFF, supra, note 1, at 170-98; Also, CEOs’ impact on their companies’ success has been difficult
to demonstrate empirically. See DORFF, supra, note 1, at 150-69.
26
See supra, note 3.
27
See DORFF, supra, note 1, at 81-84; Kevin J. Murphy, Explaining Executive Compensation: Managerial
Power Versus the Perceived Cost of Stock Options, 69 U. OF CHICAGO L. REV. 847 (2002); Kevin J.
Murphy, The Politics of Pay: A Legislative History of Executive Compensation, in JENNIFER G. HILLS &
RANDALL S. THOMAS, eds., THE RESEARCH HANDBOOK ON EXECUTIVE PAY (2012); Kevin J. Murphy,
Executive Compensation: Where We Are and How We Got There, in MILTON HARRIS & RENÉ STULZ, eds.,
HANDBOOK OF THE ECONOMICS OF FINANCE (2013).
28
See DORFF, supra note 1 (arguing that the increase in CEO pay is largely the result of the shift to
performance pay, and that the shift has not measurably improved corporate performance).
7
October 7, 2016 DRAFT – do not copy or cite
conjecture that this approach will lead to lower CEO salaries without reducing CEO quality the
“bargaining process” hypothesis.
The literature on executive compensation is vast and often contentious – and, indeed, one
of us has written a book that canvases this literature -- yet we have been unable to identify other
scholars who have advanced in print the argument that we make here. Why is this? We think the
answer is that both sides of the standard debate over CEO compensation make an implicit
assumption about the market for executive talent that we find implausible. The literature generally
assumes, usually without explicitly saying so, that firms are price takers in a thick, undifferentiated
market, while simultaneously assuming that CEO-caliber talent is in short supply. 29 Under this
assumption, a firm must bid up all the way up to its reservation price for its first-choice candidate
because, if it bids less, the candidate will be snapped up by another CEO-starved company fishing
in the same limited talent pool. Put differently, the assumption is that if Aqua Company’s true
reservation price for its first-choice candidate is really $10 million, it will have to offer that
candidate $10 million or else it will lose that candidate to another firm that offers an equally
desirable professional opportunity and has a reservation point of just under $10 million. Adherents
of the rational choice conjecture seem to assume that CEO candidates wield near-monopoly power
over firms that allows them to capture the bulk of the cooperative surplus. 30 In this world, the only
possibly relevant question concerning whether firms “overpay” CEOs is whether firms correctly
estimate the marginal productivity of CEO candidates.
We believe, however, that, at least in most cases, the market for CEOs is more
appropriately viewed as an example of bilateral monopoly. 31 Candidates have differential qualities
and abilities (although firms probably often believe these are larger than they actually are 32), so
firms are often justified in being willing to offer greater compensation for their first-choice
29
See, e.g., Gabaix & Landier (2008), supra note 2; Sherwin Rosen, The Economics of Superstars, 71 THE
AMERICAN ECONOMIC REVIEW 845 (1981); Sherwin Rosen, Authority, Control and the Distribution of
Earnings, 13 BELL J. OF ECONOMICS 311 (1982); Marko Terviӧ, The Difference That CEOs Make: An
Assignment Model Approach, 98 AMERICAN ECONOMIC REVIEW 642 (2008).
30
Id.
31
A bilateral monopoly is when there is both a monopoly and a monopsony: “the seller faces a market with
only one buyer and the buyer faces a market with a single seller.” Stewart E. Sterk, Neighbors in American
Land Law, 87 Colum. L. Rev. 55, 58 (1987).
32
See DORFF, supra note 1, at 150-69; RAKESH KHURANA, SEARCHING FOR A CORPORATE SAVIOR: THE
IRRATIONAL QUEST FOR CHARISMATIC CEOS (2002) (arguing that the CEO market is socially constructed,
with boards caring more about legitimacy than talent).
8
October 7, 2016 DRAFT – do not copy or cite
candidate in order to attract that candidate than they would for a second choice who had a more
standard managerial skill set. 33 It seems obvious that no firm would be wise to select a CEO by
holding a reverse-price auction and awarding the job to any applicant for the job who is willing to
work for the lowest salary, such as the high school dropout currently earning minimum wage
working in the mail room.
But jobs also have different qualities along a variety of dimensions, and for this reason few
candidates would be wise to simply choose whichever job offers the highest salary. Every CEO
position offers different opportunities, challenges, working conditions, geographic location, etc.
And at any given time, CEO openings are limited in number, which means a candidate must
compare them to non-CEO positions. So while a particular CEO candidate might be a firm’s
uniquely best option, suggesting it should be willing to pay a higher-than-market wage if necessary
to attract the candidate, a particular CEO position might be a candidate’s uniquely best option,
suggesting that the candidate should we willing to accept a lower-than-market wage if necessary
to secure the job in a marketplace swimming with many talented executives searching for desirable
positions.
When a job and a candidate are particularly good fits for each other, the resulting
negotiation will approach a bilateral monopoly: the firm’s reservation price 34 – the most it should
be willing to pay for the candidate’s services -- will exceed the general market rate for a CEO, and
the candidate’s reservation price will fall short of the market rate. In this situation, any salary that
falls between the parties’ reservation prices will be Pareto efficient, and there is no economic
justification for the resulting salary to be set at the firm’s reservation price as opposed to any other
point within the bargaining zone. 35
33
Note that this is precisely the opposite view from that of some scholars who have justified higher CEO
pay by claiming there is now a greater demand for undifferentiated managerial talent. See supra note 22.
34
35
Robert Cooter described the concept of Pareto efficiency as follows:
A Paretian analysis, as proposed by its inventor and greatly refined by generations of economic theorists,
first assumes that there is an initial distribution of resources, which is given outside the model. Once the
initial distribution is described, the analysis proceeds to ask whether any reallocation of resources can make
at least one person better off without making anyone else worse off. If the answer is “Yes,”' the reallocation
is a Pareto improvement. If the answer is “No,”' the initial allocation is Pareto efficient (also called “Pareto
optimal”').
Robert D. Cooter, The Best Right Laws: Value Foundations of the Economic Analysis of Law, 64 Notre
Dame L. Rev. 817, 820-21 (1989).
9
October 7, 2016 DRAFT – do not copy or cite
Under the bilateral monopoly assumption, it is a necessary but not sufficient condition of
concluding that the firm is not “overpaying” its CEO to determine that the CEO’s net marginal
revenue product exceeds that of others who might fill the position. It is also necessary to ask
whether the firm is paying its CEO more than it needs to in order to obtain the level of quality
represented by that candidate as a consequence of the bargaining process that it chooses to employ.
If this inquiry is resolved in the affirmative, it would be, in our view, proper to assert the normative
conclusion that the firm has “overpaid” its CEO, even if the net marginal revenue product is
positive and larger than would be expected if the firm hired an alternate executive. If firms’ choice
of bargaining processes result in them paying CEOs or other executives more than they would
using an alternative approach, holding quality constant, we believe it is proper to conclude that
firms overpay those executives, even if their net marginal revenue product of those executives is
positive on average (or even large).
We believe that there are three reasons to suspect that firms using the C1N2 bargaining
process will overpay their CEOs relative to what they would be able to pay if they were to employ
an N1C2 approach.
A. Bargaining Power
In negotiation, a party’s leverage, or power, 36 depends on beliefs about beliefs.
Specifically, bargaining power depends on the counterparty’s perception of the subjective value
that the party in question places on its best outside alternative, often referred to as its “BATNA”
(best alternative to a negotiated agreement). 37 This is because a negotiator with a desirable
BATNA will have a low reservation price, defined as the point at which she would be indifferent
between reaching a deal in the focal negotiation and pursuing an external alternative. 38 When
negotiating with a CEO candidate, a firm’s BATNA will almost always be to hire a different
candidate for the position. The firm maximizes its negotiating power, in this circumstance, if the
candidate believes that the firm has a low reservation price: i.e., that it will accept an impasse
rather than reach an agreement that requires it to pay more than a relatively low salary amount.
The candidate will believe the firm has a low reservation price, in turn, if he or she believes the
36
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firm places a high subjective value on hiring an alternative candidate compared to the subjective
value it places on hiring the candidate in question.
For example, if the candidate believes the firm has a reservation point of $3 million dollars
per year, the candidate should be willing to accept a salary of less than $3 million per year
(assuming the candidate’s own reservation point is not higher than $3 million per year), because
the candidate will fear that demanding more will lead the firm to hire someone else. If the
candidate believes the firm’s reservation price is $10 million per year, in contrast, the candidate
will have an incentive to hold out for substantially more than $3 million per year – as close to $10
million as possible – even if the candidate’s own reservation price is less than $3 million per year.
The candidate is more likely to estimate that the firm’s reservation price is low rather than high if
the candidate believes that the firm has strong alternative candidates; if the candidate perceives
that the competition for the position is weak, the candidate is more likely to infer that the firm has
a high reservation price because the company has no realistic alternative to head the company.
By identifying a first-choice candidate first and negotiating the compensation package with
that candidate second, the firm sacrifices bargaining power in two different ways. First, the firm
reveals to the candidate that, holding compensation constant, the firm believes that the candidate
in question would be more desirable than any other candidate. The firm does not necessarily reveal
how much more valuable it believes the candidate would be as CEO compared to other options,
but it reveals it has a preference for the candidate. This implies that the firm has a higher
reservation price than the candidate is likely to infer if it is unclear which candidate the firm would
prefer, holding compensation equal.
Second, the act of offering the position to one candidate and embarking on compensation
negotiations can itself create reputational costs should the firm later turn to its second-choice
candidate, which will reduce the quality of the firm’s BATNA and thus increase its actual
reservation price in its negotiations with the first-choice candidate. 39 If the preferred candidate is
publicly identified as such before compensation is negotiated, or if the identity of the preferred
candidate becomes public or semi-public as a result of an information “leak,” several negative
consequences can ensue. Public perceptions that the firm was unable to attract its top candidate
can be seen by investors as a negative signal concerning the firm’s future prospects. 40 Dignitary
39
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harm caused to the second-choice candidate, who now knows he or she was not the first choice,
could make it harder (and more expensive) for the firm to then hire that candidate. 41 The time lag
between the selection of the first-choice candidate and the failure of subsequent negotiations can
make the firm more impatient to hire the second-choice CEO, in order to avoid further inferences
that the firm is having trouble attracting the CEO or that the ultimate hire was not highly desired,
which might force to firm to offer a more generous compensation package to the second-choice
candidate than it otherwise would. For any or all of these reasons, a candidate could reasonably
infer that, once the firm anoints him or her as its top candidate, the firm’s reservation price will
increase, thus weakening the firm’s bargaining position.
As suggested above, when the candidate’s perception of the firm’s reservation price
increases, the candidate will gain bargaining power, and the expected compensation of the new
CEO will increase. Assume that the candidate’s reservation price for accepting the CEO position
of Aqua Company is $2 million per year in compensation (because, perhaps, the candidate
currently earns $1 million per year as Chief Operating Officer of a different company and
becoming CEO of Aqua will require him to relocate his family and to work much harder) and that
the firm’s reservation price for hiring that candidate is $10 million dollars per year. If the candidate
knows the firm’s reservation price is $10 million, the salary eventually negotiated must fall
between $2 million and $10 million dollars, with the candidate attempting to obtain as much of
that $8 million of “cooperative surplus” 42 lying between the reservation prices as possible. If the
candidate believes, incorrectly, that the firm’s reservation point is only $3 million, the candidate
will should be willing to accept a salary of $3 million, and possibly less (so long as the amount
exceeds $2 million). On average, firms that reveal that their reservation point is $10 million will
pay their CEOs more than firms that are able to conceal their high reservation points and cause
candidates to believe they have $3 million reservation points. Notice that this is true whether the
firm’s willingness to pay its preferred candidate $10 million is consistent with the rational choice
conjecture (i.e., that the first-choice candidate’s skills are such that the firm will earn at least $10
million more in profit as a result of his or her leadership compared to the next-best alternative and
thus the firm would be better off paying that candidate $10 million than hiring someone else) or
inconsistent with the rational choice conjecture (i.e., that the firm overestimates the marginal
41
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product of the first-choice candidate – or underestimates the marginal product of an alternative
candidate – and thus would be made worse off if it paid the first-choice candidate $10 million).
B. Fairness Norms
When there is a bargaining zone between the candidate’s reservation price and the firm’s
reservation price, the specific bargaining result will often have as much to do with what the parties
believe is a fair salary as with the parties’ relative bargaining power. The concept of fairness,
however, lacks a precise metric, and much depends on which of many comparisons seem to the
negotiators to be most relevant in a particular context. We believe that subtle contextual clues will
often suggest the appropriateness of a higher salary after a candidate is chosen than before.
After the candidate is offered the CEO position, we hypothesize that parties are more likely
to see the salary of existing CEOs of companies with similar features (such as firms in the same
or similar industries and with similar revenues or profits) as an appropriate reference point, and
that it will be more difficult for the parties to agree that a salary that deviates substantially from
those comparison points is fair. In contrast, before the candidate is offered the position, although
other CEO salaries present plausible reference points, we think that other reference points, such as
the candidate’s current salary or the salaries of the candidate’s current peers, are likely to also have
a patina of legitimacy, which could, in turn, make somewhat lower salaries appear to be fair.
C. Commitment and Consistency
Social scientists have long understood that human beings have a strong desire to act
consistently with their past commitments. Failure to do so creates cognitive dissonance, which is
uncomfortable. 43
By offering a candidate the CEO position, the firm’s directors make a
commitment to the prediction that the firm will prosper under that candidate’s leadership. Acting
consistently with this commitment requires treating the candidate as if she were not only adequate,
but outstanding. Offering a candidate a relatively low salary in comparison to similarly situated
CEOs, which might be a good negotiating strategy if the candidate appears to have a relatively low
reservation price, might seem inconsistent with the firm’s determination that the candidate is high
quality. Confidence in the ability of the candidate would more likely suggest the appropriateness
of a high salary compared to peers, since a high-quality candidate should have many other excellent
43
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career opportunities, suggesting that the candidate should have a high reservation price. In
addition, the firm’s evaluation of the candidate’s high ability is salient, but the fact that similarly
situated CEOs were also judged by their boards of directors to be of higher quality than their
competitors for the position is unlikely to be salient. This type of thinking can create a spiraling
effect, where each CEO hired is considered “above average” and thus offered an above-average
salary compared to her peers, and salaries are continually ratcheted up. 44
We think that if firms negotiate salaries prior to choosing CEOs, there will be less cognitive
pressure to offer those candidates salaries that are higher than average compared to the CEOs of
other companies. At the time of the negotiation, of course, the candidate would not be the
company’s CEO, only a candidate for the position, and the firm will not have a cognitive stake in
that candidate’s conditional compensation reflecting above-average quality.
III. The Experiment
A. The Negotiation Simulation
To test our hypothesis that a C1N2 bargaining process will cause firms to overpay their
CEOs, we conducted a high-context negotiation simulation, entitled “Hiring a CEO,” in which
subjects played either the role of an executive under consideration for a CEO position or the role
of a corporate official responsible for hiring a new CEO.
Subjects were randomly assigned to one of the four roles: the Chair of the Board of
Directors of Bartleby Manufacturing., Inc. (“Director”), a corporation that manufactures parts for
agricultural machinery and aircraft; Quinn Morris, Vice President and Chief Operating Officer of
Parts Manufacturing, Inc.; Sidney Murphy, Vice President and Chief Operating Officer of
Agricultural Assemblers, Inc.; or Casey Morgan, Vice President and Chief Operating Officer of
Amazing Aircraft, Inc. All subjects were informed that Bartleby recently announced the retirement
of its current CEO, Jamie Miller, and that the Director was responsible for hiring Miller’s
replacement. After a series of initial interviews, the Director had narrowed the field to three
44
See John Bizjak, et. al, Are All CEOs Above Average? An Empirical Analysis of Compensation Peer
Groups and Pay Design, 100 J. OF FINANCIAL ECONOMICS 538 (2011); Charles M. Elson & Craig K.
Ferrere, Executive Superstars, Peer Groups and Overcompensation: Cause, Effect and Solution, 38 J.
CORP. L. 487 (2013); Michael Faulkender & Jun Yang, Inside the Black Box: The Role and Composition
of Compensation Peer Groups, 96 J. OF FINANCIAL ECONOMICS 257 (2010); and Rachel M. Hayes & Scott
Schaefer, CEO Pay and the Lake Wobegone Effect, 94 J. OF FINANCIAL ECONOMICS 280 (2009).
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finalists for the position -- Morris, Murphy and Morgan – and the Director was tasked with hiring
one of the three at an agreed-upon salary.
In addition to being randomly assigned to a role, each subject was randomly assigned to a
grouping that included one subject in each of the four roles. Candidate subjects and Director
subjects were prepped in separate rooms. An experimenter read background information and
simulation instructions aloud, while subjects followed along on individual sets of written
instructions. After being prepped and given an opportunity to ask any questions, Candidates and
Directors were brought together for face-to-face meetings (with one exception, explained below).
Subjects playing the role of the Director received biographical information for each
Candidate that described that Candidate’s background and qualifications for the job. All three
Candidates boasted many years of experience as Chief Operating Officer (“COO”) of a company
in a related industry, along with B.A. and M.B.A. degrees from different but similarly elite
institutions (i.e., Harvard, Stanford, University of Chicago). The biographies were designed with
the goal of making all three candidates appear equally qualified for the Bartleby job, but for the
sake of realism each biography was different. Thus, it was an important part of the experimental
design that the Director also received a short, confidential report, purportedly prepared by a
consulting firm retained by the firm that carefully compared the Candidates and concluded that all
three were equally well qualified for the CEO position: “None of the candidates would be
meaningfully better than the others.” The Director also received information that each Candidate
currently earned an annual salary of approximately $3 million in their COO positions.
Each Candidate received the biographical information about himself/herself and was told
that he/she was competing against two other finalist Candidates for the CEO position. The
Candidates did not receive any specific information about the other two finalists, but all were told
they should assume that the others had similarly impressive qualifications. All Candidates learned
that they earned a salary of $3 million per year in their current job, but none had any information
about the current salaries of their competitors. All were told they were very interested in the
Bartleby CEO position because of the personal challenge that running a large company would
present, its likely potential for higher income than they currently enjoyed, and because (for various
reasons) it was unlikely, although not impossible, that they would become CEO of their current
company.
All Director and Candidate subjects received a “CEO Salary Table” that listed Bartleby
and eight other companies, described their industries (all were similar to Bartleby’s), listed recent
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annual sales, annual profits, profit margin, and market capitalization of the company, along with
the length of tenure of each company’s CEO and that CEO’s current annual compensation.
Bartleby’s outgoing CEO, Jamie Miller, was reported to be in his/her 8th year of service at a current
annual salary of $13.86 million. The statistics for each company varied, providing material that
subjects could use to support fairness claims for various salary levels based on the principle of
horizontal equity, but the data did not point to an obvious reference salary for the new Bartleby
CEO. All subjects, Candidates and Directors alike, were informed that the table contained publicly
available information to which all subjects would have access.
All subjects were informed that, for a CEO to be hired, the Director and one of the three
Candidates would have to agree to an amount of annual compensation. Although CEO
compensation is often divided between salary, bonuses, stock options, etc., subjects were told that,
for simplicity, parties in the simulation would need to agree to a single dollar amount of
compensation, to be referred to as “salary,” which they should assume would be divided between
fixed pay and other forms of compensation after the simulation was completed.
Identifying a subject pool that provides a suitable model for negotiations between CEO
candidates and corporate board members is obviously problematic. In the best of all worlds, the
experiment would have been conducted using senior executives at large firms – the type of men
and women most representative of the actual participants in CEO compensation negotiations. The
experiment required up to a full hour to conduct, however, and because experimental groupings
required four participants, we needed (in most cases) four subjects to generate each data point.
The labor intensive nature of the simulation made recruiting a sufficient number of executives to
serve as subjects, at any compensation level we might potentially be able to afford, clearly
impossible.
Although social science laboratory experiments most commonly use undergraduate
students as subjects, we feared this group would lack sufficient life experience and sophistication
to fully place themselves in the relevant roles. We felt that professional school students, while
obviously not as representative of the population that interests us as actual executives, would
provide a closer approximation than would undergraduates. For a number of logistical reasons,
we chose to use law students as subjects, although we believe MBA students would have worked
just as well. 45
45
[find percentage of CEOs at companies of size X that have a J.D. vs. MBA]
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Subjects were recruited from four sections of first-year law students at the UCLA School
of Law and three sections of first-year law students at Southwestern Law School. Each section
was made up of between 70 and 100 students. Students were invited to stay after class on a
particular day, scheduled in advance, and were placed into groupings for the simulation along with
other students in their section, in order to model the fact that, by the final round of interviews and
salary negotiations between CEO candidates and firm board members in the real world, the parties
would be likely to have professional relationships rather than be complete strangers. In total, 206
first-year law students participated in the experiment: 118 UCLA students and 88 Southwestern
students.
Subjects were told they would be compensated for their time, and that the experimenters
would pay them in cash immediately following the simulation. The compensation arrangement,
explained at the outset of the simulation, had two important features. First, to encourage all
subjects to put forward a level of effort reflective of what might be expected in the real world,
payments were incentive compatible: subjects who achieved better negotiated outcomes received
more money. Second, the correlation between outcomes and cash payments was greater for
Candidate subjects than for Director subjects, reflecting the fact that CEOs will receive a more
direct cash benefit from negotiating higher salaries than board of directors members are likely to
receive by negotiating lower CEO salaries for the benefit of shareholders.
All Candidate subjects earned a $7 flat fee. Candidates who were hired to be the new CEO
of Bartleby earned an additional $1 in cash for every $1 million dollars in annual salary that they
were able to negotiate. Candidates who were not hired as CEO kept their current COO positions
and earned an additional $1 in cash for every $1 million of their current salary. (Recall that each
candidate’s “current salary” was $3 million, and thus unsuccessful candidates earned $7 + $3 for
a total of $10.) For clarity, Candidates were told that if they wished to maximize their cash
earnings from the experiment, they should not accept the CEO position at a salary lower than the
salary they currently earned. Candidates knew that they shared the same payoff structure with the
other Candidates, but they did not know their competitors’ current salaries.
Director subjects were told that they earned a (hypothetical) salary of $1.2 million as chair
of the board of directors and would receive $1 in real money for each $100,000 of that imaginary
salary for their participation in the simulation ($12). In addition, they were told that they had been
given an annual salary pool of $25 million by Bartleby, some or all of which – but no more -could be used to pay the new CEO’s annual salary. Because they were instructed to keep executive
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salaries as low as possible consistent with hiring top quality talent, directors were told they would
earn an additional $.25 in real money for every million dollars that remained in the salary pool
after subtracting out the amount they agreed to pay the new CEO.
These instructions and limitations made it possible for candidate subjects to earn no less
than $10 (assuming they did not agree to accept the CEO position for less than their current $3
million salary) and no more than $32 (although they did not know the upper boundary prior to the
simulation). Director subjects could earn no less than $12 and no more than $18.25 in real money,
although they could not earn more than $17.50 in real money if no candidates would accept less
than $3 million. The average Candidate subject hired to be CEO in the experiment earned $__,
while the average Director subject earned $__ . All Candidates subjects not hired as CEO earned
$10.
To ensure that all subjects understood the incentive system, before the simulation began all
subjects received a worksheet that required them to demonstrate that they understood how their
cash compensation would be calculated. In an attempt to avoid anchoring effects, 46 subjects were
asked to calculate two payments, one based on a low CEO salary of $3 million and one based on
a high CEO salary of $22 million. The vast majority of subjects provided the correct answers to
both questions on the first try. For those that made errors, we told them that their answer was
incorrect, explained again the formula that would be used for calculating “real money” payments
for their role, and asked them to try again. All subjects provided the correct answers by this point
and were permitted to continue with the simulation.
B. Experimental Conditions
We conducted three variations of the “Hiring the CEO” simulation. In all three, subjects
were randomly assigned to play either the role of a Director or a Candidate and then were randomly
matched to one another. The control version modeled the C1N2 process that is typical in the hiring
of CEOs and other senior executives. In this version, Director subjects were given 10 minutes,
after the complete set of instructions were read, to select their preferred candidate from among the
three finalists based on their biographies and the report from the consulting firm. After Directors
chose a CEO, the Candidates were informed of the decision. Directors and their chosen Candidate
46
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then had 15 minutes to prepare to negotiate with one another, and then another 15 minutes to
attempt to reach a salary agreement in a face-to-face, free-form negotiation session.
All subjects were told that if they failed to reach agreement, the Candidate would keep his
or her current job and Bartleby would have to reopen its CEO search, but neither the Director nor
the Candidate would be a part of that process. In the event of an impasse, Candidates would be
paid $10 in real money ($7 show up fee plus $3 for their $3 million current salary) and Directors
would be paid $12 ($1 for every $100,000 of their $1.2 million salary and no bonus). Subjects did
not know the payoff structure for subjects playing the other role in case of impasse. By the end of
the time period, each Director/Candidate pair of subjects had to record their salary agreement or
indicate that they failed to reach an agreement.
1. Simultaneous Negotiation with Multiple Candidates
a. Experimental Manipulation
In experimental condition #1, Director subjects were instructed to negotiate potential
salaries with all three Candidate subjects linked to them coincident with making the final hiring
decision. All subjects were given 15 minutes to prepare for negotiations, and Directors then had
a total of 30 minutes to negotiate individually and serially with each of their three Candidates.
Directors could meet with each candidate as many times as they chose, for as along or as short a
time period as they chose, in whatever order they chose, so long as they met at least once with
each candidate. Directors could not meet with more than one Candidate at a time, and Candidates
could not communicate with each other. Within the 30 minute negotiation period, Directors could
enter into an agreement to hire one of the three candidates at an agreed-upon annual salary. As in
the control condition, subjects were told that if no agreement were reached, all Candidates would
keep their current jobs and Bartleby would have to reopen its CEO search. At the end of the
negotiation period, Directors submitted a form that indicated the lowest salary each of the three
Candidates had agreed that they would be willing to accept if hired, and identified which
Candidate, if any, they had agreed to hire.
We predicted that the processes employed in each experimental version would result in
Candidates indicating a willingness to accept lower salaries, and directors thus hiring a CEO at a
lower salary, than in the control condition. In the control condition, the Candidate selected as the
CEO designate had no way of knowing whether the Director preferred him or her strongly or only
weakly, but the CEO designee did know that, at worst, the Director would not have a higher
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reservation price for a different candidate. The CEO designee also knew that, in the event of
impasse, the director would have to reopen the selection process, at some cost to Bartleby.
These features of the negotiation provided the chosen candidates with bargaining leverage
that they did not have in the experimental conditions. In addition, we predicted that fairness norms
might point toward higher salaries, in the eyes of both Candidate and Director subjects, in the
control condition, and that the consistency and commitment bias might cause Director subjects in
the control condition to be more focused on the positive qualities of the CEO designee after
selecting him or her and thus increase the amount of salary that the Director was willing to offer.
In experimental condition #1, none of the Candidates knew whether they were the
Director’s first choice for the CEO position, holding salary equal, and the Director could switch
“favorites” at any point without suffering any costs. This meant that the Director could tell any of
the Candidates that Bartleby was indifferent between the finalists and would choose the low bidder,
that they were Bartleby’s preferred Candidate but another Candidate had submitted a sufficiently
low bid that the cost/quality combination favored that other Candidate, or even that they were the
least favored Candidate but close enough in perceived quality that a sufficiently low bid could
switch the cost/quality combination in their favor.
Although any of these claims might be false, no candidate could be sure they were false,
giving them a greater incentive to accept a lower salary offer, provided it was above their
reservation price (in this case, $3 million for each candidate). Without this uncertainty, a
Candidate who knew the firm strongly preferred to hire him or her could safely make and maintain
a salary demand close to his or her perceived marginal product, knowing that the Director was
unlikely to choose an alternative candidate unless the difference in salaries outweighed the
company’s strong selection preference.
The Director’s bargaining power comes from the
assumption – that we believe a reasonable Candidate would make – that in some situations a firm
will strongly prefer one finalist to others, but that in other situations the preference for one
candidate in the final pool will be weak, and that it is impossible for a Candidate to know into
which category a particular negotiation falls.
b. Results
Our primary interest is in the comparison of the salaries agreed upon by subjects in the
control and experimental conditions. In the control condition, all 29 dyads reached an agreement
in the allotted time period. Salaries ranged from a low of $4.3 million to a high of $11.5 million,
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with an average of $8.62 million. In experimental condition #1, Directors negotiated
simultaneously with all three finalist Candidates with the goal of reaching agreement with one.
All 23 Directors reached a salary agreement with one candidate during the time period. The
average agreement was for a salary of $6.56 million, or slightly more than $2 million less than the
average salary negotiated in the control condition. The different between the averages of the two
conditions is highly significant, 47 suggesting that the simultaneously negotiating with three
finalists before making a choice enabled the Directors to save their (hypothetical) companies a
substantial amount of money.
We anticipated that, since the instructions were explicitly designed to signal to Directors
that the three Candidates were equally well qualified for the position, Directors would hire each
candidate 1/3 of the time, and that Directors in the experimental condition would always hire the
candidate willing to accept the lowest salary. In the experimental condition, seven Directors hired
Quinn Morris, eight hired Sidney Murphy, and eight hired Casey Morgan – confirming our
prediction. We were surprised that, out of 29 Directors in the control condition, 22 selected Quinn
Morris for the CEO position, while only four selected Sidney Murphy and three selected Casey
Morgan. 48 On further reflection, we attribute this to the bias, demonstrated empirically in other
situations, in favor of candidates whose name appears first on a list of choices. 49 On the piece of
paper labeled “CEO Selection Form,” which asked each Director to “check” the name of the
Candidate that he or she wished to choose for the CEO position, Quinn Morris’s was appeared
first.
Twenty-one of the Directors in the experimental condition reached agreement with the
candidate who indicated to the Director his/her the willingness to accept the lowest salary, a result
that is sensible given our attempt to portray all three candidates as equally qualified for the
position. Two directors reached agreements with one candidate even though a different candidate
47
p = .00. For this and the other primary findings, differences are also significant when the analysis is
limited to the UCLA subjects. Differences for Southwestern subjects, of which there are fewer, are
directionally as predicted but not significant. We report all data pooled.
48
p = .00.
49
See [find studies to cite in “Friend or Foe”]. Evidence of this bias has led many jurisdictions to
randomize the order of names of candidates on election ballots. In the heavily contested 2000 presidential
election, all Florida ballots were alphabetical, listing George Bush’s name before Al Gore’s. Studies
suggest that the bias for earlier listed candidates is significant enough, even when differences between
candidates are well known to voters, that Gore would have prevailed in Florida – and therefore in the
presidential election – had the order of names been randomized. [cites]
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had indicated a willingness to accept a lower salary. One of these Directors agreed to pay Quinn
Morris $9 million in annual salary, although another Candidate was willing to accept $4 million;
a second Director agreed to hire Quinn Morris for $9 million, even though another candidate was
willing to accept $7.5 million; and a third Director hired Casey Morgan for $6 million when
another candidate was willing to accept $5 million.
In all three of these cases, the Director subjects responded to a follow-up question of why
they chose not hire the candidate willing to work for the lowest salary by explaining that he or she
believed that the Candidate hired was significantly superior in quality to the low bidder. These
three subjects were willing to sacrifice a portion of their “real money” payoff in the experiment to
vindicate their ethical role to act in the best interest of the fictional firm, Bartleby Manufacturing,
Inc. Had these three Directors hired the Candidate willing to accept the lowest salary among the
three, the average salary would have been $6.24 million, or $2.39 million less than the candidates
in the control condition.
The experimental literature on negotiation suggests that outcomes of single-issue, bilateral
negotiations, can depend significantly on which party makes the first offer. 50 Although the
bargaining context and availability of information matters as to whether making the first offer is
an advantage or a disadvantage, we predicted that, in our simulation, the party making the first
offer or demand would gain an advantage by setting an anchor for the subsequent “negotiation
dance”; consequently, we believed salaries would be lower when the Director makes the first offer
than when the Candidate makes the first demand. The presence of such an effect would not present
a problem if Directors were equally likely to make the first offer in both conditions, but we feared
that the difference in negotiation processes might differentially affect the likelihood that Directors
would make the first offer across the two conditions, which could cause what appears to be a
difference in outcomes resulting from the difference in structure between C1N2 and N1C2 to
actually result from the differential likelihood of Directors to make the first offer under the
different structures.
In light of this concern, we examined the difference between the two conditions controlling
for the identity of the party that made the first offer. In the control condition, we feared that the
custom of employers making a first salary offer to a selected candidate might cause most or all of
the Directors to make the first offer. To avoid this, we advised half of the Directors to make the
50
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first offer in the negotiation (and their paired Candidates to refrain from making a salary demand
until after the Director had made an offer), and advised the other half of the Directors to refrain
from making a salary offer until after their Candidate had made a demand (and their paired
candidates to make the first demand). Hypothesizing that there would not be a strong default
assumption concerning who should make the first offer in the experimental condition, we provided
no instruction in that condition on which party should make the first offer. In the control condition,
15 Directors reported that they made the first offer, and 14 reported that their Candidate made the
first demand (all 29 reports were confirmed by the paired Candidate). In the experimental
condition, 8 Directors reported that they had made the first offer to the Candidate that they
eventually hired, while 15 reported that the eventually-chosen Candidate had made the first
demand. In two cases, Director and Candidate provided inconsistent reports after the fact as to
which side made the first offer or demand, but the results were unaffected by whether we credited
the memory of the Director or the Candidate.
In our regression model that includes both the experimental condition and the identity of
the party who made the first offer, the identity of the first offeror is significant 51 but, importantly,
the condition remains highly significant. 52
Examining at the identity of the first offeror in each condition yielded an interesting
secondary finding. In the control condition, when Directors made the first offer the final agreement
averaged $__ compared to $___ when the Candidate made the first demand. The average
difference of $1.82 million in significant. 53 In the experimental condition, Director first offers
resulted in average final salaries that were $1.06 lower than those that followed from Candidate
first demands, but this difference was not significant. 54 The finding that the identity of the party
making the first offer mattered more in the control condition than in the experimental condition
might be explained by the intuition that the power of setting the initial anchor in negotiations
matters more in a bilateral monopoly setting in which, after the Director chooses the Candidate,
the two have roughly equal bargaining power. In contrast, in condition #1 the Director can pit the
51
p = .03 if the Directors’ memories are credited in the two disputed cases; p = .14 if the Candidates’
memories are credited.
52
p = .00 (regardless of whether the memories of the Directors or Candidates is credited in the two
disputed cases).
53
p =.05.
54
p = .37.
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three Candidates against each other, giving the Director a greater ability to negotiate down the
salary even of a Candidate who sets a high initial anchor point.
2. Solicited Salary Demands
a. Experimental Manipulation
Experimental condition #2 employed a different selection and salary-setting process. The
three Candidates were each informed that they were one of three finalists for the CEO position and
were told that, as the final step in the hiring process, Bartleby was requiring that each Candidate
indicate in writing the minimum salary that he or she would be willing to accept as CEO if they he
or she were selected for the position. By submitting their minimum salary requirement, the
Candidates would indicate their agreement to accept the CEO position at that salary. The Director
would then decide which finalist to hire, if any, based on the combination of the firm’s evaluation
of each Candidate’s qualifications and the salary cost of hiring each candidate.
After briefly greeting their Director opposite but not speaking about the CEO position, 55
Candidate subjects were allowed 10 minutes to determine their minimum salary requirement and
record it, and each Candidate’s salary requirement was then delivered by the experimenters to the
Director subject in their grouping. Director subjects then selected one of the three Candidates for
the CEO position, at the salary indicated by the chosen candidate.
In experimental condition #2, any Candidate bid higher than $3 million would create the
risk that the Candidate would lose out the job that she would have secured had the bid been lower.
The cost of this risk would have to be balanced against the potential gain that would be obtained
if the candidate were hired at the higher salary, and but the presence of that risk should create
pressure to moderate the salary demand. As in experimental condition #1, the greater downward
pressure expected as a result of the bargaining process originates from the uncertainty concerning
which candidate is favored by the Director, the strength of that preference, and the firm’s ability
to hire a less preferred candidate in terms of quality alone if that candidate turns out to be most
desirable when taking into account both quality and salary demand.
Experimental condition #2 was, in theory, quite similar to experimental condition #1. The
primary difference was that in #2, Candidates had a single opportunity to communicate to the
55
We implemented the somewhat artificial greeting so that subjects in experimental condition #2, like
subjects in the other two conditions, would know the face of the person playing the opposite role in the
simulation.
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Director the lowest salary at which they were willing to accept the Bartleby CEO position, whereas
in experimental condition #1 Directors and Candidates had multiple opportunities to communicate.
From a rational choice perspective, we would not expect this difference to affect results. In both
conditions, candidates faced the same analytical problem: they had to balance the desire to demand
a higher salary in order to increase their payoff should they be chosen to be CEO with the
imperative of demanding a lower minimum salary in order to increase the chance that they would
be selected CEO.
In experimental condition #1, Directors had opportunities to warn the
Candidates that they would not be selected if they did not indicate the willingness to accept a
relatively low salary that were not available in condition #2, but any such warning would be strictly
cheap talk: a rational Director would issue the warning whether or not a reduction in salary was
necessary for a Candidate to be selected and, knowing this, a rational candidate would offer the
same minimum demand regardless of whether the Director claimed a lower demand was necessary.
b. Results
In experimental condition #2, all Directors successful hired one of the three Candidates, as
was also the case in the control condition and in experimental condition #1. The salaries of the 14
new CEOs averaged $7.58 million (ranging from a low of $4 million to a high of $13 million),
about $1 million less than the average for the control condition. The difference between these falls
short of statistical significance, 56 although we had fewer subject groups in condition #2 than in the
control condition and condition #1, so our power is somewhat low. Two out of the 14 Directors
chose to hire a Candidate who did not submit the lowest salary requirement, notwithstanding that
this reduced their real-money compensation from the experiment (in both of these cases, the
Directors hired Quinn Morris despite the fact that in one case Casey Morgan and in the other case
Sidney Murphy submitted a lower salary requirement). Had these two Directors chosen the lowest
bidders among the candidates, as they could have, the average salary would have fallen to $7.15
million. The difference between this lowest salaries bid by the condition #2 candidates and the
salaries negotiated by the control condition Candidates is statistically significant. 57
Our
interpretation of these results is the variation on the N1C2 hiring process tested in condition #2
had the effect of reducing salaries but not do the extent of the process tested in condition #1.
56
p = .14.
57
p =.05.
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What explains the difference between the condition #1 and condition #2 results? Our
hypothesis is Candidate subjects tend to make relatively high initial salary demands in an N1C2
process as a consequence of what is alternatively known as “optimism bias” or “self-serving bias.”
While the specific process tested in condition #1 enabled Directors to respond to unreasonably
optimistic initial demands, the process employed in condition #2 does not allow for any corrective.
A rational Candidate should submit a high minimum salary requirement if he or she knows
that the Director heavily favors him or her. This is because, if the Director believes that Bartleby
will earn tens of millions of dollars more in annual profit under a the leadership of a particular
Candidate, it will be rational for the Director to choose that Candidate even if he or she demands
several million dollars more than the others, and the higher demand allows the Candidate to capture
more of the available cooperative surplus. On the other hand, a rational Candidate should submit
a bid that is much lower if he or she believes that the Director is indifferent between the Candidates,
favors one of the other two Candidates, or only slightly favors the Candidate in question. In this
situation, a Candidate who does not bid at or below the level of the other Candidates is unlikely to
be hired, in which case he or she will not, of course, enjoy any cooperative surplus.
In the “Hiring a CEO” simulation, the Candidates have no reliable information concerning
whether they will be the preferred candidate or whether any preference the Director might have is
strong or weak. The Candidates know that they are well-qualified for the CEO position, but they
have no specific knowledge of their competitors’ qualifications, and the instructions advise them
to assume that the other finalists are also well-qualified. We believe that this accurately reflects
the relative information candidates will have usually have in the real world.
After the condition #2 Candidates provided their minimal salary requirement, but before
the Directors chose Candidates to be the new CEO, we asked each to provide his or her estimate
of the percentage likelihood that they would be hired if they and their two competitors all had
submitted exactly the same minimum required annual salary. Given their complete lack of
comparative information, we believe that the normative answer for candidates in any of the three
roles is 33.3%. But a large social science literature documents that, on average, individuals tend
to overestimate their skills relative to their peer group, 58 at least in areas in which they possess
58
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some skill in an absolute sense, 59 and that they tend to be more optimistic about the likelihood of
experiencing positive events in the future than facts warrant. 60
In our study, all Candidate subjects estimated their likelihood of being chosen as CEO if
they and their two competitors submitted identical minimum salary demands at an average of
61.1% (an obviously highly significant different from 33.3% 61) suggesting the presence of a strong
self-serving bias. Of the 42 subjects playing the role of Candidates in condition #2, only four
provided the normative response of 33% or 33.3%, and only three others provided estimates of
less than 1/3. The level of bias varied little, and non-significantly, across roles, with subjects
playing Quinn Morris estimating that they were 66.4% likely to be the favored candidate of the
three, subjects playing Sidney Murphy estimating their likelihood at 61.0%, and subjects playing
Casey Morgan estimating their likelihood at 56.0%.
62
The fact that successful Candidates in condition #1 were willing to accept the CEO position
at a lower salary than the successful Candidates in condition #2 appears to be explained by the
difference in process, rather than by any difference in the extent to which their self-evaluations
were biased in a self-serving manner. We asked Candidate in condition #1 the same question that
we asked Candidates in condition #2 – “how likely do you believe you would have been selected
for the position if all three Candidates made exactly the same salary demand” – but the condition
1 subjects responded to the question after they had the feedback of knowing whether or not they
had been hired. Surprisingly, this difference in timing appeared to have essentially no effect on
Candidates’ beliefs in their own relative merit. The 23 Candidates hired in condition #1 responded,
on average, that there was a 65% likelihood they would have been hired if all three Candidates had
demanded the same salary. Perhaps this evaluation was reasonable given the knowledge these
subjects had that they had actually been chosen to be CEO. But the 46 Candidates who were not
hired (and knew this!) in condition #1 provided the statistically indistinguishable average response
that there was a 63.2% likelihood that they would have been hired if all three Candidates had
demanded the same salary. With their belief in their own merit apparently unaffected, we
59
In contrast, individuals tend to be underconfident about their relative skill in areas in which they have
little absolute skill. [cite]
60
61
p = .00.
62
p = .29.
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hypothesize that these Candidates concluded that they lost out only because another Candidate had
indicated a willingness to work for substantially less money.
3. Morale Effects
Our experimental results appear to support our theory that N1C2 processes would enable
companies to hire the same high level executives at lower total compensation levels that the more
common C1N2 process. But this approach might well be penny-wise and pound-foolish if the
savings on compensation would come at the cost of irritating, insulting, or embittering the new
CEO. Given the effect that a CEO’s performance can have on corporate profits (or at least is
presumed to have on corporate profits), boards of directors will not wish to risk onboarding even
a modestly soured executive, who might then work just a little bit less hard or a little bit less smart
on behalf of the company. And perhaps N1C2 would provoke a negative reaction on the part of
candidates, either because the process is not customary, or because it will tend to result in lower
compensation.
We tried to test this conjecture in the experiment and were unable to find any data
suggesting negative morale consequences of either N1C2 approach. We asked every Candidate
subject who was hired for the CEO position in all three conditions to rate, on a scale of 1-7, their
level of enthusiasm for the agreement that was reached, their perception of whether they were
treated fairly by the firm in the negotiation process, and their level of motivation to lead Bartleby
Manufacturing, Inc. as its new CEO. We found no evidence at all, much less statistically
significant evidence, that subjects subjected to “N1C2” processes were insulted, offended, or
otherwise miffed at their treatment in the hiring process. Control subjects, on average, rated their
“level of enthusiasm for the agreement [they] reached” at 5.2, with a score of 1 representing “least
enthusiastic” and 7 “most enthusiastic.” Condition # 1 subjects, who engaged in salary negotiations
before being chosen, provided an average response of 5.4 Control subjects, on average rated the
agreement’s fairness at 5.5, with 1 representing “least fair” and 7 “most fair.” Condition #1
subjects gave an average response of 5.35. Neither of these differences are significant. Control
subjects, on average, rated their motivation to lead Bartleby at 5.7, with 1 being “least motivated”
and 7 being “most motivated.” Condition #1 subjects provided an average rating of 6.3. This
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difference is significant, 63 but it runs counter to the predicted direction: the CEOs who might have
been offended by the process expressed greater motivation to lead.
Experimental condition #2 subjects were subject to what might be considered by some to
be a coercive hiring process, having been required to state their minimum acceptable annual salary
before being offered the CEO position with the understanding that this would be the amount they
would be paid if hired. But, at least for our subjects, this group expressed the most positive feelings
about the hiring process and the firm. They rated their level of enthusiasm for the agreement at
6.2, the fairness of the agreement at 6.4, and their motivation at 6.6.
In sum, our simulation detected no hint that employees subjected to N1C2 hiring processes
would feel more negatively about the process or the firm than subjects who engaged in typical
C1N2 process.
The lack of lower levels of morale among Candidates in experimental conditions #1 and
#2 compared to the control condition reflect our finding that Candidates in the experimental
conditions reported that their view of what salary would be objective “fair” for the CEO position
was much lower than the view of Candidates in the control conditions. This result is consistent
with our conjecture that Candidates (as well as Directors) negotiating over their salary before being
offered the job would likely view their current salaries as plausible reference points, along with
the salaries of CEOs of other companies, whereas Candidates (and Directors too) negotiating a
salary after already having been anointed the new CEO would be more likely to focus their
attention only on other CEO salaries. 64
Control group Candidates on average reported that a salary of $8.79 million would be fair,
a significantly higher amount than condition #1 Candidates who were hired 65 ($5.35 million) and
condition #2 Candidates who were hired ($7.50 million). 66 Director views of what salary would
have been “fair” closely tracked those of the Candidates in the control condition and condition #1.
Directors in the former group reported an average fair salary of $8.26 million compared to $5.43
million for those in the latter group. Both the Directors’ and Candidates’ evaluations of what
would constitute a fair salary are likely to affect the salary actually negotiated, and indeed the
63
p = .01.
64
See Part II, B. supra.
65
p =.00.
66
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fairness evaluations of both groups are significantly correlated with the negotiated salaries across
all three conditions. 67 But it is the Candidates’ differential views of what salary would be fair for
the CEO position based on the negotiation process used that are likely to explain the same level of
enthusiasm on the part of Candidates in the experimental conditions who were paid millions less
(hypothetically, of course, but these differences were also reflected in the subjects’ real-money
payments) than those paid millions more.
IV. Why Do Firms Use C1N2?
If firms could, in fact, reduce the compensation of their CEOs and other executives without
suffering a drop in quality by employing an N1C2 hiring process, as our theory and experimental
results suggest, why do firms instead use C1N2? In this section we consider several possible
explanations, which we organize from least plausible (in our opinion) to most plausible.
A. Director Self-Interest
Perhaps firms know they are overpaying their CEOs and continue to do so because this
benefits the directors who hire the CEOs, even though doing so hurts shareholders. Many scholars
who believe that CEOs are overpaid, in the sense that their marginal salaries exceed their marginal
productivity, believe that overpayment occurs because corporate directors wish to curry favor with
CEOs, who can reappoint them to board seats and potentially bestow other favors on them. 68 The
same logic -- that directors are something less than faithful agents for the firm’s owners -- could
explain why firms choose to use a hiring process that benefits CEOs at the expense of shareholders.
Although we cannot completely rule out this explanation, and although it probably does
apply in some isolated cases, it seems unlikely that director malfeasance can explain a practice that
appears to be as universal as C1N2. Surely not all directors out of self-interest and contrary to
their fiduciary obligations. 69 In addition, the desire to curry favor with the future “boss” cannot
explain why firms also often use the same procedure when hiring executives who are not the boss.
67
For Candidate fairness views individually, p = .00, and for Director views individually, p = .00. When
both are included in a regression model, the Candidate fairness views remain highly significant, p = .00,
but the Director fairness views become not significant. P = .18.
68
See supra, note 3.
69
We also have our doubts about the validity of this theory more generally. See DORFF, supra note 1, at
91-119.
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To take one example, universities usually employ a C1N2 process when they make lateral faculty
hires, carefully deciding who they believe is the best candidate for the opening and issuing an
“offer” before attempting to agree on compensation. But, to the best of our knowledge, the
administrators who employ this process obtain no personal benefit from lining the pockets of those
faculty members.
B. Transaction Costs
C1N2 has the advantage of limiting the number of salary negotiations to one for each CEO
(or other employee) chosen. These negotiations can be time consuming, and even more so when,
as is the case for CEOs, negotiations cover a range of issues, not just a single salary figure.
The higher transaction costs associated with N1C2 could contribute to the demonstrated
preference in the market for C1N2, but these seems implausible as a complete explanation. The
search process required to hire a CEO or other senior executive is nearly always time consuming
and expensive. Conducting salary negotiations with a few people, instead of only one, is not likely
to add substantially to the total cost of the hiring process. To the extent it does add some cost to
the process, the opportunity to reduce compensation by, in some cases, millions of dollars will
almost always justify the costs. In addition, pre-selection negotiations with CEOs and other senior
executives can be simplified in the real world exactly as we did in our experimental simulation,
thus sharply reducing transaction costs. The firm can negotiate compensation as a single dollar
figure, and after the CEO is hired that amount can be divided between compensation categories
like bonuses and stock options. There are standard accounting procedures for valuing these exotic
elements of compensation in dollars, as the SEC already requires publicly traded companies to
express complicated compensation packages in absolute dollar terms in filings. 70
This explanation seems more likely to explain the choice of C1N2 when it is used to hire
lower-level executives not subject to as thorough of a hiring process as CEOs.
C. Wide Disparities in Evaluations of Candidates
N1C2 provides firms with greater bargaining power than C1N2, because, in the first
process, the firm has a more credible threat to hire a different candidate if the first-choice candidate
demands too high of a salary. This advantage will not accrue if firms strongly prefer one candidate
70
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to another and candidates know this, even if candidates do not know which candidate is the
preferred one.
In interviews with public company directors, one of us has found that many assert that it is
nearly always the case that boards of directors have an extremely strong preference for one
candidate over all others, such that financial sacrifices that a second-choice candidate might offer
to make would not outweigh the first-choice candidate’s perceived marginal value. 71 If this is both
true and common knowledge among candidates, finalists for a position might reason that they
would be best off negotiating in exactly the same way that they would under a C1N2 process.
Under this assumption, any candidate in a group of finalists might be the first choice, and she
might not be the first choice. If it turns out that she is, in fact, the first choice, demanding the same
high salary that she would if in a C1N2 process would not reduce her chances of being hired, but
would be likely to result in greater compensation if she is the first choice. If it turns out that
another candidate was the company’s strong first choice, by definition, no concessions that the
candidate might offer in negotiations would vault her above the first choice candidate in projected
net value. Thus, the candidate would forego no advantage if she negotiated in this situation exactly
as she is the favored candidate, just as she would in the C1N2 setting. With candidates adopting
the same tactics under either process, firms would have no reason to suffer whatever marginal
transaction costs or social costs that would be associated with the N1C2 approach, and thus might
rationally decide to C1N2.
The empirical assumptions necessary under this theory to point in favor of N1C2 is quite
restrictive and seem unlikely to be satisfied in the real world. Although firms often have a strong
preference for one finalist candidate over the others, it seems quite likely that, in at least some
cases, boards of directors assess the value of two or more candidates as being similar. Because
candidates would usually not know whether they were participating in a process in which one
candidate was a strong favorite or one in which two or more were assessed similarly, candidates
would have a strategic incentive to moderate their negotiating demands, at least somewhat, in a
N1C2 process as compared to a C1N2 process.
D. Procedural Fairness Norms
71
See DORFF, supra note 1, at 159-69. See also supra, note 31.
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A more plausible explanation for why firms do not insist on N1C2 hiring processes are that
they fear candidates will resist committing to compensation arrangements before being selected
for a position. The firm could insist that candidates engage in a N1C2 process as a condition of
being considered for the position, of course, but this could harm the important relationship between
firms and their potential executives. There are two possible, slightly different concerns in play
here. First, candidates put off by a N1C2 process might refuse to participate in the process at all,
causing the firm to lose out on the chance of hiring a top candidate. Second, candidates might
participate in the process but resent it because they find it insulting or unfair in some way. Such
resentment might, in turn, increase the risk of moral hazard: a new CEO who feels mistreated in
the hiring process might not do as good of a job for the firm, ultimately costing the firm far more
in the long run than it might hope to save in the short run.
This explanation is plausible on its face and might rightly give firms pause about instituting
N1C2 hiring processes for CEOs and other senior executives. If the hiring process leaves
successful candidates believing they have been treated unfairly, sapping their motivation or
dedication, the upfront salary savings could be dwarfed by the long-term cost to firm profits.
As described above, we could find no evidence that the two N1C2 hiring processes that we
tested experimentally created any such negative feelings in our subjects. But, of course, this is
hardly definitive proof. The first problem ends at the conclusion of hiring process. Our subjects
never proceeded on to actually performing the job in question, even hypothetically, so we do not
know what feelings they might have had or attitudes they might have displayed at such a time.
The second and more obvious problem is the external validity concern. Our subjects were students
who are not, in fact, senior executives, and they might not share the expectations and sensibilities
of actual senior executives. It is possible, of course, that real executives, imbued with corporate
norms and culture, would react more negatively to N1C2 than student subjects, who lack that
experience and, perhaps, knowledge of corporate hiring norms.
E. Substantive Compensation Norms
A related possibility is that substantive norms concerning what constitutes fair
compensation for CEOs, and for other senior executives, might dominate strategic bargaining
considerations in executive hiring, such that firms would not actually take advantage of whatever
bargaining power advantage they theoretically could generate by choosing an N1C2 hiring process.
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Assume that Candidates A and B, the two finalists for the CEO position at Aqua Company,
have reservation prices of $2 million per year for taking the job. Aqua Company’s directors
believe that the firm will earn $4 million dollars per year more in profit with Candidate A at the
helm than Candidate B, but neither Candidate has access to this internal evaluation. If Aqua
employs a C1N2 process, it will first offer the position to A. If it believes B would accept the job
for $2 million, Aqua should be willing to pay A up to $6 million per year in compensation (i.e., $4
million more than it would have to pay B). In the subsequent salary negotiation, a strategic A
could use the knowledge that she is Aqua’s first choice and the knowledge that it would be costly
for Aqua to declare an impasse with A and open negotiations with B to negotiate a salary relatively
high in the bargaining zone between $2 million and $6 million, thus capturing much or most of the
cooperative surplus. In contrast, using a N1C2 process, Aqua might, in theory, use the power it
derives from the enhanced credibility of its threat to hire B in order to convince A to accept a salary
closer to $2 million, thus enabling the firm to capture more of the cooperative surplus.
But it might also be the case that industry professionals would agree that $4.5 mm per year
is the “fair” salary for the CEO of Alpha, perhaps because $4.5 million is the average salary of
other CEOs of similarly-sized companies in the industry. Although Aqua could perhaps use the
leverage of N1C2, to force A to accept a salary of closer to $2 million, it might reasonably decide
that the potential savings it could achieve by exercising greater bargaining power would be
outweighed by the negative (although difficult to measure) consequences of having an unhappy A
moving into the CEO suite feeling that she was being underpaid. 72 Thus, to maximize morale and
motivation, boards may feel compelled to offer their CEO a package comparable to that enjoyed
by CEOs of similar firms, even if the candidate has no other job options and the board has many
excellent candidates. A policy of paying the CEO based on industry comparisons rather than
negotiating vigorously over pay may in the end aid companies by ensuring corporate leadership is
maximally productive. In the extreme case, the board might pay the CEO $4.5 million even if the
CEO tells the board out the outset of salary negotiations that he would work for $2 million and
negotiations would not even be necessary for the firm to save money.
Firms that follow such a norm might rationally choose to implement a C1N2 strategy. If
the firm will pay the same amount of compensation regardless of its negotiating strategy, it might
72
Similarly, under a C1N2 process, A might be able to use its relative power to squeeze some extra funds
above $4.5 mm out of the Aqua, but the costs of tension with his new board of directors might make the
game not worth the candle.
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as well minimize transaction costs and express the greatest amount of exuberance for its preferred
candidate. C1N2 is likely to be a somewhat cheaper process because it only involves negotiating
with one candidate. It is also more likely to foster a good relationship with the new CEO because
it suggests that the board strongly preferred the CEO to the other finalists.
This theory, like the prior one, depends an unproven empirical assumption. In particular,
the theory demands that firms embrace substantive fairness norms that require them to pay a new
CEO based on a particular conception of the “market price” for executive talent, regardless of
where the negotiating leverage lies. Further work is necessary to determine whether such norms
are widespread, or exist at all.
V. Conclusion
We have presented a “Bargaining Process” theory that firms pay CEOs and other senior
executives more than is necessary to secure their services, thus contributing at least in part to
exploding levels of executive compensation, and have presented the results of a highly
contextualized laboratory experiment that supports that theory. If the theory is correct, the
question remains as to why firms would persist in relying on a C1N2 negotiation process rather
than adopting some version of N1C2. We have suggested and critiqued five explanations for why
a suboptimal practice continues to be widespread. Some are more plausible than others, but none
are fully convincing. We hope this study will stimulate further research into these questions to
determine which explanation is correct, and whether negotiate first, choose second is a normatively
desirable approach to bargaining with the CEO.
35