Moses Maimonides, Profit Maximization and the Case of a Disabled Actor

I recently posed the following discussion question to students in my web-based human resource management course:

>"Your name is Daryl F. Zanuck, co-founder of Twentieth Century Fox. It is the early 1950s. A talented actor, recently graduated from Yale Drama School, asks to meet with you. He says that he wants to be a leading man for Fox. The problem is that the actor is missing an eye. He had lost an eye in a childhood illness. You tell him that although he has acting ability, it is not realistic for someone missing an eye to be a leading man. Appearance is an essential job requirement, a job related requirement or a business necessity, and you cannot consider him for such a role. Only one in a million people gets to be a movie star. Someone missing an eye has to be ruled out. The answer was "no".

(1) Did Zanuck make the right decision?
(2) What are the two or three chief ways to validate staffing decisions and employment tests?
(3) Did Zanuck apply a potentially validated selection criterion?
(4) Does your answer to (3) matter to your answer to (1)?

All students must participate. Do not wait until the last minute as failed postings will not get credit."

Of the twenty-odd responses, only two or three said that it might be possible that the actor should be hired. Most said that he should not. Several students contrasted profit-maximization (not hiring) with altruism (hiring). None suggested that the profit maximizing decision would be to hire the actor if he were competent.

The following response was typical:

>"Depending on how you look at it the decision that was made could have been right or wrong. The two ways of looking at it is the legal way or your own selfish way. Legally the decision Zanuck made (may be) against the law, since it's discrimination to reject some one due to a defect or appearance (if they're the best qualified and reasonable accommodation can be made). But on the other hand if I was looking from my own selfish point of view I made the right decision because the job does require appearance and for this job he was not the right candidate even though he might have been an outstanding actor but sex sells."

(Technically, the above answer is incorrect because if appearance is an essential job requirement, as it is with actors, then the Americans with Disabilities Act does not mandate hiring.)

The question is a trick one, because it is based on the A&E biography account of Peter Falk.

Wikipedia's entry on Peter Falk states:

"Falk's unusual gaze is due to a glass eye that he has had for most of his life. His right eye was surgically removed at the age of three because of a malignant tumor."

According to the Peter Falk official site, Falk has appeared in 38 films, to includ "Murder, Inc.", "It's a Mad, Mad, Mad, Mad World", "A Woman under the Influence", the (1979) original "In Laws" in which he co-starred with Alan Arkin, "Wings of Desire" and "The Sunshine Boys". He has been nominated for two Academy Awards. Imdb.com indicates that he has appeared in 130 television shows.

Falk is best remembered for his starring role as Detective or Lieutenant Columbo, one of the best known and most memorable roles in television history.

According to Falk's A&E Biography, Daryl F. Zanuck told him that he could not be a star because of his eye.

In Economics of Discrimination Gary Becker showed that not discriminating, basing hiring decisions on pure performance criteria, is profit maximizing. Thus, economic justice and the maximization of profit coincide. The individual who best fits the job ought to be hired regardless of race, creed or disability.

The idea that a disabled actor might be best qualified is not intuitively obvious. Human resource management ought to serve the end of rationalization; HR ought to overcome psychological and social biases and develop employment methods that are profit maximizing. This is an ethical quest. However, the rationalism of good human resource management is seldom appreciated because it does not acknowledge the egos of senior managers, who may flatter themselves into believing that their judgment is more reliable than methods that are statistically validated over long periods of time. One example might be not doing something stupid like hiring an actor with a glass eye.

In fact, few American firms utilize human resource management policies that could improve financial performance to the extent that they might. One example is in hiring boards of directors. I have not heard of firms using statistically validated selection methods in hiring boards. The idea is almost never suggested. Yet, current governance problems could be swept away if the current "I shoot pool with a guy so let's put him on the board" approach to corporate governance is replaced by identification of the skills needed; development of ability, knowledge or assessment center tests; and application of those tests to the rational selection of corporate boards.

The equation of justice and ethics has Aristotelian roots and has many links to the Judeo-Christian tradition. In an article in Online Athens Ronald Gerson discusses the ideas of Moses Maimonides, the famous Aristotelian Jewish philosopher, about the rungs of charity:

>"While he emphasizes anonymity in the higher rungs, when he reaches the eighth and highest level, this is what he says: 'The highest form of charity is to strengthen the hand of the poor by giving him a loan, or joining him in partnership, or training him out of his poverty, to help him establish himself.'"

That is, the best form of charity is to enable people to help themselves. This is done by empowering them with competence and the ability to succeed on their own. Good human resource management involves uncovering the competencies that can best support firms' performance; finding most competent employees; and finding ways to enable the most competent employees to flourish.

Review of Pay without Performance: the Unfulfilled Promise of Executive Compensation

Pay without Performance: The Unfulfilled Promise of Executive Compensation
Lucian Bebchuk and Jesse Fried
Cambridge, Mass.: Harvard University Press, 2004
278 pages

Pay without Performance is a well-written book that provides a post-'90s update to Graef Crystal's 1991 In Search of Excess. Bebchuk and Fried recast the 75-year old debate about executive compensation that began with Berle and Means's 1932 Modern Corporation and Private Property into two alternative models: the arm's length bargaining and the managerial power models. Their assessment, which is similar to Crystal's, is that managerial power has guided executive compensation practices and led to excesses that the authors catalogue, updating Crystal's book. Their book is more theoretical than Crystal's, but it is theoretical in an accessible and elegant way that is a pleasure to read.

Like Crystal, Bebchuk and Fried argue that top managers' extraction of rents has not been and will not be resolved by spontaneous market forces. In other words, top executives have found loopholes in the structure of the American corporation and have learned to use the loopholes to their financial advantage. The amounts of excess compensation that executives extract are probably too small per shareholder to concern the shareholders. This is so even though executives extract large sums.

Bebchuk and Fried do not discuss the broader social implications of the separation of pay from performance, but it is probably serious. Public support for the market system and belief in hard work is likely eroding because of the example that CEOs have set.

Also, Bebchuk and Fried do not discuss the role of both macroeconomic factors and human resource management factors that would potentially address the problem of excessive CEO compensation. First, with respect to macroeconomic factors, low interest rates make this issue more salient than it would be in a free market environment without loose Fed monetary policy.

As Bebchuk and Fried point out, managers have taken advantage of general stock market returns that have been boosted by low interest rates. That's not the sole cause of excessive compensation because managerial compensation is not very well-correlated even with general stock market returns. However, declining interest rates cloak shoddy management by boosting stock prices. We have been living in a twenty-five year old stock market bubble caused by increasing money supply. Any bubble is characterized by excesses in fields like executive compensation. When interest rates rise, top pay will subside. Top manager self-dealing and pontification will always exist, but it will seem less disturbing as the worst-managed firms go under and the amounts shrink.

I don't believe that improving the design of incentives will alter the pattern of self-dealing to the degree that Bebchuk and Fried believe. There is an unresolved paradox in the executive compensation literature. First, Jensen and Fama (1983), for example, claim that the hiring of insiders as directors and the informal hiring processes that characterize selection of board members can be explained by the quest to optimize board expertise. "(I)t is natural that when the internal decision control system works well, the outside members of the board are nominated by internal managers. Internal managers can use their knowledge of the organization to nominate outside board members with relevant complementary knowledge."

In fact, Jensen and Fama's contention diverges from decades of research with respect to employee selection. Formal selection methods such as structured interviews, IQ tests, job knowledge tests and work samples are superior (in psychological parlance more valid) than informal processes such as impression or subjective evaluation. Anyone with real world knowledge of the corporate world knows that executives "manage" impressions about their competence.

Moreover, there are agency problems involving board appointment such as quid pro quo, the hiring of board members who are unlikely to rock the boat and interlocking appointments. That agency theory was oblivious to the distortions of the abstract model of board governance, and the open secret of "ol' boy networks" in board appointments seems hard to believe in the post-Enron world.

The paradox is that at the same time that agency theorists have argued that "ol' boy" network board hiring practices result in more capable boards, they also argue that because of special failings of CEOs, such as risk-aversion, that result from the practices, executives deserve higher pay. As Bebchuck and Fried note, top managers tend to be risk averse and so need to be motivated with stock options. Jensen and Fama, Murphy and others claim that supply of qualified executives is wage inelastic because there are so few qualified executives. This seems contradictory. If current executives have problematic personality traits such as risk aversion, just what about them is so desirable that their supply is wage inelastic? More importantly, no one in the executive compensation literature seems to have been eager to ask these questions: What are the specific competencies, if any, that qualify executives? Where are the studies that validate the supposed competencies? Why aren't corporations falling over themselves to identify this obviously valuable information? Why, instead, do corporations insist on the secrecy of selection methods, competence information and validation of board member and executive selection?

In the book Good to Great, Jim Collins (2001) points out that the best executives focus on teamwork, set up their successors for greater success than they have achieved, display compelling modesty, are self-effacing and understated, focus on sustained results, and attribute success to factors other than themselves but take full responsibility for failure. Collins notes that these traits are not rare among the general population. They are just rare among current top managers! In other words, boards have failed to even begin to apply systematic methods to top manager selection. This would seem to be related to the character weaknesses that Bebchuk and Fried find commonly displayed in top managers' indifference to their fiduciary duties. Collins notes (p.39):

"I believe that (such) leaders exist all around us, if we just know what to look for, and that many people have the potential to evolve (into great leaders)."

If Collins is right, then there are important staffing issues. Why these aren't discussed in the compensation and governance literature is a puzzle. Where are the competency studies to identify traits necessary for directors? For CEOs? Are there systematic approaches to selecting directors, or do CEOs hire to boards guys with whom they play golf or shoot pool? I wonder how many firms use objective selection criteria in choosing a CEO or director before they are interviewed.

In 1990, Lex Donaldson (1990, paid access) criticized organizational economics and agency theory, which holds that interests of principals and agents diverge; that their interests can be aligned through incentives; and that shirking or non-compliance with ethical or contractual obligations needs to be addressed with efficient contracts and rewards. Donaldson argued that agency theory puts too much methodological emphasis on individualism. In the management literature, Donaldson pointed out, agency theory is known as MacGregor's "theory x". MacGregor argued that people who believe in theory x believe that workers cannot be trusted, that they need to be motivated by financial incentives and that they need to be monitored. In contrast, people who believe in "theory y", which MacGregor advocated, believe that people can be trusted, that they are naturally creative and that they aim to achieve.

Donaldson pointed out that most of the time people need to be motivated with a combination of theory y and theory x, but agency theory is too narrowly focused on theory x. "Organizational economics creates a theoretical scenario in which managers act opportunistically."

Donaldson argued that stewardship theory is an alternative model to agency theory. Rather than a conflict of interest between principals and agents, stewardship theory would propose that managers are team players and that "the optimal structure is one that authorizes them to act in the owners' interests". Donaldson argued that many of the governance reforms that Bebchuck and Fried propose, such as having increasingly independent directors and allowing shareholders to select directors independently of the CEO, would contradict the prescriptions of stewardship theory. Donaldson was concerned that both agency theory and stewardship theory might be too broad.

Things seem to have deteriorated since Donaldson's article. In the 1980s, there was talk of what William Ouchi (1981) called Theory Z: high trust human resource management and tight organizational culture. Ouchi argued that such arrangements are optimal because they reduce transactions costs. Similarly, until his death in 1993, W. Edwards Deming (2000) the creator of many of the ideas behind total quality management, argued that long term thinking, driving fear out of the workplace and elimination of performance appraisal were essential to good management.

Current CEO pay practices seem to have thrown the "stewardship" theory out the window. Bebchuk and Fried do not even consider that organizational culture and high trust necessitate current pay practices. If not, then it would seem that the best hopes of management theorists like MacGregor, Ouchi and Deming have been dashed. Rather than behave as part of a coherent, organic organization in which social relationships with employees and with society play a paramount role, today's executives in Bebchuk's and Fried's view function as manipulators who can be influenced by incentives, if only their tendency to outsmart the incentive plan can be overcome. This is very far from traditional "stewardship" management theory.

Instead, Bebchuk and Fried contrast the agency model with the managerial power model. According to the agency model, CEOs may engage in (p.16) "empire building, which can increase their prestige, perks, compensation and other private benefits...They may run companies in ways that are personally satisfying or convenient even if they come at the expense of shareholders. They may be tempted to pursue pet projects, for example, or they may fail to take actions that are personally costly, such as firing mediocre subordinates who also happen to be their friends." According to agency theory, directors (p.17) "take an independent position vis-a-vis executives" and bargain at arm's length." In order to counteract such tendencies, firms need to link pay with performance. But because executives are characteristically risk averse, linking pay to performance means that pay amounts must increase.

Bebchuk and Fried argue against the agency model of arm's length bargaining. Executives do not (p. 23) "instinctively seek to maximize shareholder value" so there is "no reason to expect a priori that directors will act in this way." In particular, directors of the thousand largest firms earn $116,000 just for serving on the board. They would not want to jeopardize their compensation by fighting over the CEO's pay given that the CEO is largely the one who appoints them. Moreover, most boards emphasize collegiality, so even if money is not the issue, the cultures of corporate boards involve norms that inhibit questioning the CEO's pay demands. There are also factors like friendship, reputational risks and, if the directors are themselves highly paid CEOs, cognitive dissonance.

Shareholders have a few ways to intervene, such as through law suits, voting on option plans, or resolutions, but these methods turn out to be ineffective. Likewise, takeover bids are unlikely just because of executive compensation. The 40 percent premium that takeovers require are usually too great for the one to three percent effect on stock prices due to excessive executive pay to justify.

The relatively weak correlation between executive pay and firm performance; the reissuing of stock options at lower strike prices; the use of camouflage whereby true pay amounts are not admitted or are disguised through the use of pension formulas or by failing to disclose the tax effects of deferred compensation all suggest that the exercise of managerial power rather than arm's length bargaining determine executive pay. Bebchuk and Fried do not consider the possibility that these behaviors are part of the adaptive corporation that Alfred Dupont Chandler (1962) described in Strategy and Structure. Such a claim would be far fetched.

Bebchuk and Fried present research findings that suggest that CEO power plays a role in determining pay. CEO compensation increases in tandem with the size of the board. The probability of getting a golden parachute is greater when more board members have been directly appointed by the sitting CEO. Lower institutional ownership leads to higher and less performance sensitive executive compensation. Managerial power seems to be linked to pay.

Bebchuk and Fried do an excellent job of cataloguing the different ways that boards camouflage pay through retirement pensions, deferred compensation, post-retirement perks, consulting fees and loans. They also point out that (p. 121) "managers have used their power to secure pay without performance." Cash compensation has at most weakly correlated with performance. It is, however, associated with cash windfalls that firms receive, for instance when they win a lawsuit or terminate a pension plan with excess assets. In those cases executives get a nice piece of the windfall. Executives of acquiring companies are often paid bonuses, even though acquisitions almost always result in a decline in the acquiring firm's stock price. Only 30 percent of share prices reflect corporate performance with the remaining 70 percent due to market factors like interest rates. Yet, almost all executives are compensated on the raw share price rather than on a sector-adjusted share price.

The authors, like Crystal (1991) argue against restricted stock. I take issue with that particular argument. If the value of the restricted stock is adjusted so that executives are equally well off, I would think that restricted stock is better than options. The reason is that options might encourage excessive risk taking. A large holding of stock (and nothing else) would seem to put executives in the same position as shareholders. Of course, the parenthetical "and nothing else" is the devil in the deep blue sea.

The authors conclude with a convincing set of recommendations that focus on the issue of compensation. As I have already noted, my claim is that the problem may be one of executive and board selection rather than governance and compensation.

Overall, this is a very good book. It is clearly written, practical, theoretically sound and a joy to read.

References

Collins, J. 2001. Good to Great: Why Some Companies Make the Leap and Others Don't. New York: Harper Business.

Chandler, A.D. 1962. Strategy and Structure. Cambridge, Mass.: MIT Press

Deming, WE. 2000. Out of the Crisis. Cambridge, Mass.: MIT Press.

Donaldson, L. The Ethereal Hand: Organizational Economics and Management Theory. 1990. Academy of Management Review, 15:3. 369-381.

Ouchi, W. G. 1993. Theory Z.

Jensen and Fama. 1983. "The Corporation and Private Property." Journal of Law and Economics. 26:2

Gotham's Colleges

My following article appears in the December 6,2006 issue of the New York Sun based on an article I wrote in the Spring 2006 issue of Academic Questions.

Gotham's College$
By MITCHELL LANGBERT
December 6, 2006

The College Board recently reported that the cost of a four-year college degree is up 35% from four years ago after adjusting for inflation. At four-year private colleges, costs are currently $13,200 after financial aid adjustments, and at public colleges they are $5,836. The College Board estimates that from 1989 to 2005, college tuition inflation was almost double the rate of general inflation, 5.94% versus 2.99%.The reason for the ever-increasing costs is lax management. The solution is improved university governance.

The adjacent table shows that, in the New York region, baseline tuition ranges from $36,088 at Sarah Lawrence College to $4,157 at the City University of New York. Baseline tuition at Columbia and New York University is $35,166 and $33,420, respectively. University presidents' salaries similarly vary. They range from Shirley Kenny's $287,000 at SUNY Stony Brook to John Sexton's $789,989 at NYU. Note that, with a couple of exceptions, presidents at the higher-priced institutions tend to earn more than presidents at the lower-priced institutions.

Lax administration rather than faculty salaries explains high tuitions. An increasing percentage of professors are adjuncts, parttime faculty members paid on a per course basis. Adjuncts earn peanuts. CUNY's heavy reliance on adjunct faculty explains its modest tuition. Most adjuncts earn under $5,000 per course, even when a large lecture course generates $180,000 or more in revenue. In 2005, the Chronicle of Higher Education reported that while nationally, colleges employed 60,000 more professors in 2003 than in 2001, the increase for full-timers was only 2% whereas the increase for adjuncts was 10%, resulting in a 50-50 ratio of full-timers to adjuncts. This trend may be related to adjuncts generally not receiving health insurance as well as to their low direct pay.

Moreover, average full-time faculty pay excluding health insurance has approximately tracked inflation. In 2004, inflation was 1.9%, while full-time faculty pay increased on average 2.1%. If the average associate professor makes $90,000, including health and retirement benefits, while the average adjunct makes $25,000, the average of the two is $57,500 including benefits. The result of averaging the modest pay increases for full-time faculty with the low salaries of adjuncts suggests that faculty salaries cannot explain tuition increases. Indeed, executives in many other industries would envy universities' ability to substitute part-timers for fulltimers.

Insiders know that administrative and facilities' costs are a large percentage of total higher education costs, though it is difficult to get universities to admit to how much. Currently, the federal government caps the percentage of administrative costs of university research grants — for which colleges have to delineate all expenses — at 26% and allows an unlimited amount for facilities. Yet, colleges argue that the cap is restrictive and should be eliminated.

In the spring 2006 issue of the journal Academic Questions, I wrote an article in which I correlated university expenses, student characteristics, endowment growth, denominational affiliation of the university, geographic region, ranking, and category of institution with university presidents' pay. The strongest correlations are between presidents' pay and revenues and between presidents' pay and expenses. In addition, revenues and expenses per student have strong, slightly above .5, correlations with university presidents' pay.

Economists like to think in terms of incentives. What are the incentives that university presidents face with respect to tuition? They are that higher budgets and higher costs per student are, at least on the surface, associated with higher presidential pay. Thus, college presidents not only have no incentive to contain tuition costs, they also may have incentives to see that tuition increases, especially if tuition is linked to increases in overall revenue and expenditure.

Some economists have argued that budget size ought to be associated with university executive pay levels because decisions of executives of large universities have larger effects than decisions of executives of small universities. However, this claim is debatable because executives of larger universities have larger staffs to whom they can delegate difficult decisions, have larger budgets for consultants to provide them with advice, and find it easier to obtain funding from public and private sources. Presidents' pay should not be increased because they spend more.

One way to resolve the debate is to see whether factors that are unarguably related to institutional performance, such as the entering students' SAT scores, the school's tier, and the percentage of classes with fewer than 20 students, have a larger effect than factors that are unarguably unrelated to institutional performance, such as enrollment, religious affiliation, and the kind of college, such as liberal arts, university, and so forth. It turns out that enrollment, expenses, religious affiliation, and kind of institution explain most of the variability in college presidents' pay, while performance-related factors such as SAT scores explain almost none.

Universities have expended almost no effort to create incentives that might encourage university presidents to cut costs and constrain tuition. Moreover, it is difficult for outsiders to assess management even in the best of circumstances, yet colleges continue to use not-for-profit financial disclosure methods that are designed to leave outsiders in the dark about what university managers are doing.

Thus, those who are concerned about rising college tuition should look to reform the management of universities. In that regard, two steps would be effective. First, parents, students, and government should insist that universities issue financial statements that include information that is specifically relevant to colleges, such as facilities, operations, and instructional costs per student. Second, they should insist that university trustees begin to grapple with the design of appropriate incentives that will motivate university presidents to constrain rather than to expand costs.

A number of approaches are available. For example, university presidents could be paid bonuses when tuition is reduced. They could also be rewarded for improvements in faculty research productivity, students' participation in extracurricular activities, and improvement in performance on achievement tests. Trustees who have the skills and motivation to monitor presidents could be hired, and such trustees could develop strategic plans, linking presidents' pay increases to achievement of specific objectives. Trustees could also increase their interaction with faculty and administration to learn about cost-saving ideas. They could base merit pay for faculty and administration on cost reduction and increased student performance.

To implement such management policies, universities would need to develop objective measures of student performance, student participation, and faculty research productivity that would be made public. The sunlight of public disclosure would likely prove effective in limiting tuition hikes.

Mr. Langbert is an associate professor of business management and finance at Brooklyn College and may be visited at democracy-project.com.