Manager Pay Inequality and Market Power

This paper asks whether managers are paid for market power. Bao, De Loecker, and Eeckhout build a general equilibrium model in which firms compete oligopolistically in goods markets (following Atkeson and Burstein 2008) while managers are allocated to firms through a competitive matching market (following Gabaix and Landier 2008 and Tervio 2008). The model identifies two distinct channels through which market power and firm size jointly determine executive compensation: a market power channel, whereby a more productive firm charges a higher markup given its output level, and a firm size channel, whereby higher total factor productivity expands output given markups. Because manager ability and firm type are complementary inputs into TFP, assortative matching arises: high-ability managers sort into high-type firms, amplifying both productivity dispersion and markup dispersion across firms.

The authors estimate the model year-by-year using Simulated Method of Moments on Compustat data covering 1994 to 2019, targeting ten moments including the average salary share, markup distribution, employment, and manager compensation levels. Firm-level markups are estimated using the production approach of De Loecker, Eeckhout, and Unger (2020). The ExecuComp variable TDC1 — encompassing salary, bonus, restricted stock grants, and option grant values — measures manager pay. Finance, insurance, and real estate sectors (SIC 6000–6799) are excluded.

Main findings: market power accounts for on average 45.8% of total manager pay over the sample period, rising from 38.0% in 1994 to 48.8% in 2019. Over the full period, average CEO compensation (net of reservation utility) roughly doubled, from approximately $2.94 million to $6.43 million. Of the $3.49 million cumulative increase, $2.02 million (57.8%) is attributed to rising market power, with the remainder ($1.47 million) due to the firm size channel. The market power channel’s dominance is concentrated among top managers: for the highest-ranked managers in 2019, 80.3% of pay is attributable to market power, and nearly all of their pay growth since 1994 stems from the market power channel. For lower-ranked managers, pay is determined primarily by the firm size channel and has been roughly flat over the period.

Within the market power channel, changes in technology — specifically increasing dispersion in firm-level TFP — are the dominant factor, contributing $1.33 million (65.9% of total market power channel growth). The increasing importance of manager ability (rising parameter alpha) contributes an additional $1.14 million through the market power channel. Within the firm size channel, TFP change accounts for 70.1% ($1.03 million) of growth, but the large effects from rising alpha and rising complementarity (gamma) are substantially offset by increasing dispersion in firm type. Structural estimates confirm that the average number of firms per market declines from 4.40 to 3.15, and firm-type dispersion (sigma_z) rises from 0.51 to 0.77, both consistent with rising market power over the period.

A counterfactual economy with no market power — firms priced at marginal cost — would yield a social welfare gain of 58.4% on average. The welfare cost of market power in 1994 could be offset by a 33.8% TFP increase; by 2019 the required TFP offset had risen to 51.7%. Without any market power, even the most talented managers would earn only their reservation utility, because firms earn zero profits regardless of productivity, eliminating the complementarity-driven matching surplus that makes top managers valuable. This confirms that superstar manager pay is intrinsically tied to the existence of market power in goods markets, not solely to firm size.

Scope conditions: the model applies to publicly listed US firms covered by Compustat and ExecuComp. The mechanism relies on Cournot competition within oligopolistic markets, assortative matching between managers and firms, and complementarity between manager ability and firm type (elasticity of substitution gamma estimated to be negative throughout the sample). The findings on market power share apply to CEOs specifically; the authors argue the same logic extends to all managerial positions with span-of-control over other workers, which encompasses roughly one-fifth of the workforce.

Q: What are the two channels through which manager pay is determined in the model, and how do they differ mechanically? A: The market power channel captures how a given level of TFP translates into higher markups — more productive firms charge more above marginal cost — thereby increasing profits per unit of output. The firm size channel captures how higher TFP expands the quantity of output a firm produces, increasing total profits through scale rather than through price-cost margin. Both channels raise profits and thus the marginal product of managers, but they operate through distinct economic mechanisms: one through pricing power and the other through productive scale.

Q: What is the empirical magnitude of the market power channel’s contribution to manager pay levels and growth? A: Market power accounts for an average of 45.8% of total manager pay over 1994–2019, rising monotonically from 38.0% in 1994 to 48.8% in 2019. For the total pay increase of $3.49 million over the period, $2.02 million (57.8%) is due to the increase in market power, with the remaining $1.47 million attributable to the firm size channel.

Q: How does the market power channel’s importance vary across the manager ability distribution? A: For the highest-ranked managers, 80.3% of total pay in 2019 is attributable to market power, and nearly all of their pay growth since 1994 runs through the market power channel. For the lowest-ranked managers, pay is almost entirely explained by the firm size channel and has been approximately flat over the period. This heterogeneity arises because top managers sort into high-markup firms through assortative matching, making their compensation disproportionately dependent on those firms’ market power.

Q: How does the model generate assortative matching between manager ability and firm type? A: Manager ability and firm type are complementary inputs into TFP (the CES aggregator with elasticity of substitution gamma less than one), which makes the matching output supermodular. In a frictionless matching market with transferable utility, supermodularity guarantees that high-ability managers match with high-type firms in equilibrium (Proposition 1). This positive assortative matching then amplifies productivity and markup dispersion, since the most productive firms become even more productive and gain larger market shares.

Q: What structural changes drive the rising importance of market power in manager pay over time? A: The dominant factor within the market power channel is changes in technology, specifically increasing firm-type dispersion (sigma_z rising from 0.51 to 0.77), which contributes $1.33 million or 65.9% of market power channel growth. The rising importance of manager ability (alpha, the weight on manager ability relative to firm type in the TFP aggregator) contributes another $1.14 million. The number of firms per market declines from an average of 4.40 to 3.15, further reducing competitive pressure and amplifying the markup premium for high-productivity firms.

Q: What does the counterfactual with no market power (first-best pricing) imply for manager pay and social welfare? A: Without market power, firms price at marginal cost and earn zero profits regardless of productivity, which eliminates the surplus from manager-firm matching. All managers would earn only their reservation utility, which is negligible relative to actual compensation. Social welfare would increase by 58.4% on average. The efficiency cost of market power — measured as the TFP increase needed to offset welfare losses — rose from 33.8% in 1994 to 51.7% in 2019, indicating a worsening welfare distortion over the period.

Q: How are markups measured, and what is their trend in the data? A: Markups are not directly observable and are estimated using the production approach of De Loecker, Eeckhout, and Unger (2020), which recovers firm-level price-cost margins from production data without requiring price data. Average markups in the Compustat sample rose from 1.53 in 1994 to 1.78 in 2019. The reduced-form elasticity of manager pay with respect to markups (controlling for firm characteristics, year, and firm fixed effects) increased substantially: in 2019 a one-percent increase in firm-level markup raises manager pay by 0.41 percent, which is 70.1% larger than the effect estimated in 1994.

Q: How does the paper handle the identification challenges inherent in regressing manager pay on markups? A: The reduced-form regression (with firm fixed effects, year effects, and interactions of year dummies with markups) documents a robust positive correlation but cannot establish causality due to reverse causality and omitted-variable bias. The paper addresses this by embedding the markup-manager pay relationship in a structural model where both are jointly determined by primitives — technology, market structure, and manager ability — and estimating those primitives via Simulated Method of Moments. The quantitative decomposition into market power and firm size channels derives from the model structure rather than from identifying variation in an instrumental variables sense.

Q: What do the matching model estimates reveal about manager-firm complementarity over time? A: The estimated elasticity of substitution between manager ability and firm type (gamma) is negative throughout the sample, confirming complementarity. Gamma was relatively stable before declining sharply from -2.22 in 2014 to -3.55 in 2019, indicating that manager ability and firm type became substantially more complementary in the latter part of the sample. The importance-of-manager parameter alpha is small (consistent with Gabaix and Landier 2008) but generally increasing, suggesting managers play an expanding role in determining firm-level TFP over time.

Q: What are the broader macroeconomic and distributional implications of the findings? A: Because approximately one-fifth of workers supervise other workers, the market-power-driven premium in managerial pay has implications beyond CEO compensation for the shape of the earnings distribution. The rise in top-1-percent income is identified as an efficiency concern, not just an equity concern: the best managers are hired by high-markup firms where they generate profits for shareholders but disproportionately little additional social value. Assortative matching between top managers and top firms widens the productivity gap between competitors, increasing market power and deadweight loss — the social return to managerial talent is therefore below the private return in equilibrium.

Market Power Channel: The component of manager pay attributable to how a firm’s TFP raises its markup — the ratio of output price to marginal cost — given the level of output. Distinct from the firm size channel; operates through pricing power rather than scale.

Firm Size Channel: The component of manager pay attributable to how a firm’s TFP expands output quantity given markups. Increasing output scale raises total profits and thus the marginal product of the manager even absent any change in price-cost margins.

Assortative Matching: The equilibrium allocation of high-ability managers to high-type firms, arising because manager ability and firm type are complementary inputs into TFP (supermodular matching output). Matching is determined in a frictionless market with transferable utility.

Markup: The ratio of output price to marginal cost, equal to the inverse of the price elasticity of demand under the nested CES preference structure. Endogenously determined by the firm’s sales share within its oligopolistic market and the elasticities of substitution within markets (eta) and across markets (theta).

Manager-Firm Complementarity: The property that manager ability and firm type are imperfect substitutes with elasticity of substitution gamma less than one in the TFP aggregator. Complementarity is the necessary condition for positive assortative matching and for the supermodularity of matching surplus.

Span of Control (Lucas 1978): The mechanism by which a manager raises the productivity of all workers under supervision, so that a more able manager generates a proportionally larger productivity gain the larger the firm. Provides the microfoundation for why firm size amplifies the value of manager ability.

Market Structure: The number of firms in each oligopolistic sub-market (Ij), which varies across markets and over time. Together with the distribution of firm-level TFP within a market, market structure determines how much competitive pressure limits markup extraction. Average firms per market declines from 4.40 to 3.15 over 1994–2019.