6 July 2000 Superstar salaries – commercial reality or economic anomaly?

Bewildered by telephone-number salaries for media stars and sky's-the-limit pay-outs to former public servants? Here Lincoln University's Professor of Economics, Peter Earl, sheds some theoretical light on what determines mega buck pay packets:

How should we make sense of the burgeoning earnings of senior executives in the public and private sectors, along with high profile signs of business expenses possibly getting out of control and severance packages the size of substantial Lotto wins?

The study of Economics offers a variety of perspectives on this and they generally give a major role to the modern trend towards short-term business reporting and high accountability. The analysis presumes that those who receive the high pay have no moral qualms about selling themselves to the highest bidder, even though the moral dimension may exert significant influence on the kinds of jobs people are prepared to do.

The traditional perspective offered by Economics relates to ‘marginal revenue productivity’ versus ‘marginal cost’ – in other words, how much extra revenue arises following an increase in expenses.

Joe or Joanna Public might well be happy to read the news for, say, $30,000 a year, but if television personality John Hawkesby can add a million dollars more per year in revenue to the employing media enterprise in question, then it could be worth paying almost a million dollars a year more than would need to be paid to get Joe or Joanna Public to do the job.

Even if John Hawkesby earns so much that his employers are only one dollar better off than they would be by having Joe Public read the news, then they may still hire him since that extra dollar is still worth having.

The same goes for managers who can make a major difference to their employers' earnings through their skill or their connections – they are in a position to capture much of the extra net revenue they enable their employers to earn.

What stops exceptional performers from capturing all the extra revenue they generate is the presence of rivals who are prepared to do the job for less. Suppose Richard Long is the next best newsreader and adds only an extra $750,000 in revenue but is willing to read the news for a mere $500,000 per year. This would leave $250,000 in profit. If so, John Hawkesby, despite his superior productivity, is now worth paying only $750,000, not one million dollars, because he must offer the TV channel at least as good a net profit.

If, however, the third-best newsreader generates $500,000 in extra revenue and is prepared to read the news for a mere $200,000, both Hawkesby and Long will have to lower their demands.

For all the would-be newsreaders, the crucial question is how much they can earn in other jobs. Clearly, if Hawkesby's next best earnings come from radio and amount to only $500,000, he might be prepared to read the news for only slightly more than this, leaving the TV station with nearly $500,000 profit.

A major problem here is that those who hire the big revenue generators cannot be sure how far they can limit their offers without losing the desired employee. Even if (and it's a big if) the person's impact on revenue can be identified with confidence, it may be very difficult to guess the total worth of the job to the person in question – reading the news may open up opportunities for earnings from other sources – and/or the next best alternative that the person might be able to get.

Suppose Hawkesby's next best earnings are really $600,000 and that in ignorance of this, he is offered only $550,000 by the TV station. If he rejects the offer and the TV station then (just!) succeeds in hiring Long for $500,000, a very expensive mistake has been made. If Hawkesby had been offered $600,000, profits would have been increased by $400,000, whereas hiring Long now adds only $250,000 to the profit.

Cautious managers, worried about profits and wary of such risks, could well end up offering more than they need to, leading to escalating pay for the superstars.

The concern with profits has a lot to answer for in explaining the Hawkesby saga. There are many attractive-looking people who could acquire skills in reading from an autocue with appropriate sensitivity, humour and so on, if only they were given the chance.

In principle, the threat from this possible competition should stop existing newsreaders from capitalising on their crowd-pulling potential. But, in the short term, the impact in terms of lost advertising revenue could be substantial, so the board of a TV station facing short-term reporting requirements is unlikely to be able to make credible threats to the established superstars.

Matters might be rather different if TV station boards were appointed on a long terms basis, with members' terms expiring at different times and a major part of the remuneration being an end-of-contract performance bonus based on the whole period of service.

These remuneration packages are often inflated in part by the riskiness of such careers. If an executive is fired after making a spectacularly unsuccessful business decision, it might be very difficult for them to find a similar kind of job ever again. Since the person would seem over­qualified for lesser jobs, the result may be a forced early retirement.

Given this risk, one would only step up into such a job with a very major increase in salary that would cushion the costs of retirement if one ended up ‘carrying the can’.

A basic problem here is that high-level decisions are often taken in the face of uncertainty and ambiguity and it would be very difficult to demonstrate what would have happened if a different choice had been taken. Consequently, the market has a huge problem in separating bad luck from bad judgment where an executive had not been taking decisions at that level for very long and has not, therefore, been able to demonstrate that most of the time his or her judgment is good.

If the present day demands for accountability lead to the likelihood that senior staff will not be given a second chance, then they will demand much higher remuneration than under a system that is prepared to judge them over the long term. Likewise, those with good track records will seem less risky to hire and if in short supply will be able to bid for high pay even though they have their track records to fall back on if a decision goes wrong.

‘Talking heads’ may not run such risks associated with the complexity of the business environment, but they do run risks of falling out of fashion and getting into a downward earnings spiral as they are demoted to lower profile jobs. The fall and fall of Kiwi Derryn Hinch on (and from) Australian current affairs television illustrates this well.

Problems of information are at least as important in the story as the competence of those who receive high pay. Writings on the ‘economics of superstars’ make it clear that high earnings may be commanded by those who are widely known to offer a product that is adequate and free of risk.

The point is much the same as that which explains the mass consumption of McDonald's hamburgers. To many they may not be the pinnacle of hamburger cuisine in terms of taste but you know where you are with them, just as you do when switching on to a familiar newsreader or buying a Madonna CD in preference to one by an unknown artist.

It might well be that many professors of business subjects could run a company, if invited to do so, at least as successfully as Sir Selwyn Cushing, and would be prepared to give it a go for a fraction of the cost. However, since they are not known quantities in this context and mistakes could be expensive, they are not asked to demonstrate their ability, and hence never build up a track record, and never get asked. That's why the same, safe ‘high-profile’ names figure time and again in appointment announcements. People have ‘brand equity’ just like that embodied in the maxim "No one ever got fired for buying IBM".

(Peter Earl is Professor of Economics at Lincoln University. Despite writing many books on business strategy and consumer psychology he has never been asked to serve on a corporate board!)

Peter Earl, Professsor of Economics, Lincoln Univeristy, Canterbury, New Zealand

Ian Collins, Journalist, Lincoln University, Canterbury, New Zealand