CEO pay and the Lake Wobegon effect

In this paper, we propose a new explanation for the recent increase in CEO pay at US firms. Our explanation, which is based on asymmetric information in financial markets, is motivated by a recent observation made by former DuPont CEO Edward S. Woolard, Jr.: "The main reason (CEO) compensation increases every year is that most boards want their CEO to be in the top half of the CEO peer group, because they think it makes the company look strong. So when Tom, Dick, and Harry receive compensation increases in 2002, I get one too, even if I had a bad year.... (This leads to an) upward spiral" (Elson, 2003). We present a game-theoretic model of this phenomenon, which is known in the business press as the "Lake Wobegon Effect." Our model has three key features: (i) there is asymmetric information regarding the manager's ability to create value at the firm; (ii) the pay package given to the manager must convey information about the manager's ability to create value at the firm; and, (iii) the firm must have some preference for favorably affecting outsiders' perceptions of firm value. We characterize the perfect Bayesian equilibrium of this model, identify conditions under which pay is distorted upward relative to a full-information benchmark, and then embed our model in a simple assortative matching framework. Our analysis offers a potential explanation across-country differences in CEO pay growth, and suggests that greater shareholder involvement in the pay process may be counterproductive.