With banks being bailed out all over the place these days, many people are asking themselves why those in charge get paid such high salaries. Are CEOs really worth their million pound bonuses? Not according to Venkat Venkatasubramanian, who has calculated that US chief executives get paid nearly 130 times what they should.
As a professor of chemical engineering at Purdue University, Indiana, Venkatasubramanian seems an unlikely candidate to dictate CEO salaries. It turns out that the maths behind thermodynamics, the study of heat and energy, can also be applied to economics.
The trick is to redefine a concept called entropy. In thermodynamics entropy measures the disorder of a system. Imagine a box full of gas particles. If all the particles are packed into one corner, the system has low entropy. If they are spread out and zooming all over the place, it has high entropy. The laws of thermodynamics mean that entropy always increases over time.
What does that mean for CEO salaries? Venkatasubramanian realised that entropy could be seen as a measure of “fairness” in economics. According to the laws of supply and demand, as markets evolve salaries and the price of goods should move towards the most fair situation for everybody.
With this economic equivalent to entropy, Venkatasubramanian found that salaries should follow a lognormal distribution, a particular way of measuring the spread of data. When he compared his theory to data from income tax returns, he found that the model fit closely for the bottom 90-95% of salaries. In other words, the 5-10% at the top are getting more than their fair share.
According to the lognormal distribution, CEOs should be paid a little over 8 times more than the average employee. Looking at the salaries of 35 CEOs from top Fortune 500 companies, Venkatasubramanian discovered that their pay was on average 1,057 times what a regular employee earns – around 129 times the ideal value.
Of course, not all CEOs pull in such vast amounts. Interestingly, investment guru Warren Buffet takes a salary of $200,000, which is about 8 times what the average employee of his company Berkshire Hathaway earns.
Venkatasubramanian points out that his figures only work for large corporations – the heads of smaller entrepreneurial start-ups will clearly be worth more than the few staff they employ. Still, he hopes that his research will be useful to governments and regulators in assessing CEO salaries, and ensuring a fair deal for all.
Venkatasubramanian, V. (2009). What is Fair Pay for Executives? An Information Theoretic Analysis of Wage Distributions Entropy, 11 (4), 766-781 DOI: 10.3390/e11040766