Show Me The Money! (Part 4)

(This post is part of a multi-post thread, and is in response to Part 3.)

Show Me The Money: Value for Value Applied

Ok minions, now that we have taken that giant step back to look at the big picture lets take the knowledge that we have learned from our lessons on Corporations and Economics of Exchange and apply it to the question at hand: Why do CEO's make so much money?

Value For Value Applied: Change in the Ranks at Minions, Inc.

Lets say, theoretically, that you are a member of a board of directors for Minions, Inc. Your current CEO (Brian) is making $1 million, and is about to retire. Brian has been doing a good job around the place, in fact he regularly pulls in $9.9 million for the owners in pure profits. Now you need to pick a new CEO.

Through your recruiting efforts you have narrowed that search down to two candidates. You feel that the first, Charles, will increase your profits by $0.2 million (bringing profits to $10.1 million). The other recruit shows more promise, he is a high level executive from Followers, Inc, named Erwin. You feel that Erwin can do a better job than Brian and Charles because Erwin has been in the industry longer, he has been able to manage his employees better, and he has a stronger skill set. You feel that Erwin will increase your profits by $1.1 million (bringing profits to $11 million).

As a member of the board you need to look out for the interests of your bosses (the owners) and give them as much of a return on their money as possible. In negotiations with Erwin you offer him the same compensation as your current CEO, $1 million. But, unknown to you and the rest of the board, Erwin has been heavily recruited by other corporations who left their final offer at $1.3 million. Erwin feels that he can make the corporation at least $0.5 million more money than Brian so he says, "You know, I'd really like to work here, but I've been offered a better offer elsewhere…. If you offer me $1.4 million we'll call it a deal."

Here are the thoughts of the board: Charles would increase our profits by $0.2 million with no change in costs; Erwin would increase our profits by $1.1 million with the increase cost of only $0.4 million; the owners would see an increase in profits of $0.7 million with Erwin, while with other candidates it would only increase $0.2 million with other candidates. They perceive the value of Erwin to be greater than value of the money they need to pay him (Erwin > $).

If Erwin knew his competition (Charles) better and if he knew what the board valued his performance at ($1.1 million minus costs) he could have increased his compensation to $1.9 million and thus matched the increase in profits ($0.2 million) that the next best candidate (Charles) could have brought the firm (that’s called opportunity cost), and still would have been hired.

Value For Value Applied: Scarcity

Now tie this lesson on value-for-value to scarcity. In this case it would be the large demand of companies needing competent CEO's while being supplied with a small supply of competent CEO's. Forbes wrote an interesting article with this tag line: "What does it cost to attract first-class talent to a chief executive job? A lot. What does it cost to hire a clunker? Almost as much."

Hopefully this post wasn't to dense to be easily grasped, the next post will be shorter and make it more apparent why CEO's make so much money.

Show Me The Money! (Part 3)

(This post is part of a multi-post thread, and is in response to Part 2.)

Show Me The Money: Economics Of Exchange

In this post, we are going to go a bit abstract and broad in order to set the groundwork for subsequent posts, so please bear with me (and feel free to ask questions in the comment area).

Economics Of Exchange: Spicy Chicken Sandwich

Four years ago, I would often go to Carl's Jr. and order a delicious Spicy Chicken Sandwich (SCS) for only $1 [although I still do but the SCS is now a lot smaller so I go a lot less]. Oh, how I loved the SCS - and at only a buck, WHAT A DEAL! After all, I value the SCS at about $2.50 (meaning I would be willing to pay as much as $2.50 for it) - this means that I am getting a consumer surplus (what I value the SCS at minus actual price) of $1.50.

Now let’s say that I develop Gastric Reflux Disease and cannot handle spicy food anymore, heaven forbid, without experiencing excruciating heartburn. Suddenly a SCS is not nearly as enticing; in fact, I now value it at only 25 cents. This means that for my spicy hot sandwich I am only willing to pay (I only value it at…) 25 cents. Therefore, every time I go to Carl's Jr. I would not purchase a SCS because I value my $1 more than the value I would receive from the sandwich (which is now only 25 cents). At any amount of money above my 25-cent mark, I would not buy, but if they were selling it at 25 cents or less, I would then feel that it is a good deal and would then be willing to buy one.

Economics Of Exchange: Value for Value

Believe it or not, my minions, you make decisions like this every day - mostly subconsciously. Really think about it … Why did you do you get BLANK Consumer Good for $BLANK? The first Spicy Chicken Sandwich example enables us to boil down exchange to the very root: value ($) in exchange for value (SCS). My viewpoint: I value my $1 less than I value Carl's Jr.'s SCS, therefore I am willing to give up the value I would have with my $1 in exchange for the value I would gain from Carl's SCS [$ (less than sign) SCS]. Carl's Jr.'s viewpoint: I (Carl) value my SCS less than I value your $1, therefore I am willing to give up the value I would have with my SCS in exchange for the value I would gain from your $1 [$ (greater than sign) SCS].

In the heartburn example the actual sandwich didn't change - it still had a spicy and juicy breaded chicken fillet, mayonnaise, crisp green lettuce, all in between a sesame seed bun. The ONLY thing that actually changed was the amount of value I placed on the sandwich - its perceived value - how I viewed the sandwich and how much I would gain from it. That is exactly how exchange works, everyone values everything differently – and somehow we all are able to make trading decisions based on that knowledge.

Show Me The Money! (Part 2)

(This post is part of a multi-post thread, and is in response to Part 1.)

Show Me The Money: Corporations

Nearly everyone on this great nation is employed by a corporation, in all its many glorious forms. But what is a corporation anyways? We can look at it in a multitude of ways, but we will only point out two. First, the law states that it is a separate and distinct entity unto itself. This enables it to sue and to be sued. This is how many of us view it, as a giant singular thing. Unfortunately, this point of view neglects the broader, more "nobler" definition: It is a vehicle which a group of people works together to obtain a collective goal. For our purposes, we will focus on this definition. Now, to explain this "group of people working together" we must focus on how a corporation is organized.

Corporations: Publicly Traded Organizational Model

Most corporations are set up in the following manner:

First, there are the owners. In publicly traded companies (on a stock exchange), an owner is anyone who owns a portion of the company (in the form of stocks or mutual funds). Many of you may be such an owner. Owners have the rights of voting on certain business decisions, as well as a proportionate share in the profits made by the company. The owners are the single most important group within the corporation.

Second, there are the board of directors. Board members are decided on by a vote by the owners of the company. The board’s role is to decide on the overall direction of the company, and to determine who the titled officers are. In essence, the shareholders have delegated to the board to watch over the company. The board reports directly to the shareholders.

Third, there are the titled officers (CEO, CFO, COO, President, etc.); we'll call them chief officers. The chief officers actually do the day-to-day running of the corporation. They are chosen by the board, as is their compensation. In essence, the board members have delegated to the chief officers to run the company. The chief-est of the chief officers is the CEO (Chief Executive Officer) who reports directly to the board. All other chief officers report to the CEO.

Fourth, there are the high-level and mid-level managers, as well as white-collar and blue-collar workers. For our purposes, we will simply refer to this group as employees. Power and responsibility trickle down to this group of workers. Employees report to their respective manager.

Corporations: Why They Exist

Despite popular opinion, a corporation is not there to make your life better or easier, if you work for a corporation it is not there to pay your paychecks, it is not there to help you pay for your house, it is not there to make you happy by making you food, or clothes, or computers. No, stop it, do not argue with me, it isn't there for any of those reasons. The sole purpose for the existence of a corporation, without exception, is to make money for the owners. Owners, after all, are investing their own money into this corporation - they expect to make a return on that money, just as you do when you invest in the stock market. All those other things are merely a by-product of making money. Now, to explain why these are just a by-product of making money we need to lay a bit of groundwork from your economics class…

Show Me The Money! (Part 1)

Show Me the Money: Intro (this will be a multi-post theme)

Minions, I am going to continue with my economic kick because I have recently noticed a negative and ignorant sentiment underway in this great nation. That sentiment is wrong, and has its underlying root in greed, and covetousness. I don’t mean to sound like I'm preaching from a pulpit or anything but yes covetousness really does apply in this case.

People are beginning to refer to the millions of dollars that the big bad CEO's are making as "excessive". I understand why this idea is gaining ground (especially recently), namely: thousands of workers every month are being laid off (1,200,000 million this year according to Fortune Magazine - That is a scary big number); and according to 2007 Money Magazine article, the average compensation of a CEO ($10,800,000 - yes, that is a lot of zero's) was 270 times larger than the average compensation of a full-time year-round worker in a non-managerial job ($40,000).

Now before we get all emotional and grab pitch forks, we must take a quick step back and determine what on earth would possess a corporation to pay a CEO so much more than they pay everyone else. We will accomplish this step-by-step enabling my minions to see the big picture (if your still not convinced you then have my permission to riot with pitch forks in the streets - also did I mention that I sell pitch forks?). To understand this "excessive pay" we must look at what exactly a corporation is...

Disclaimer: Main Street Post

Some of you may be wondering if my thoughts were biased in some way (shame on you for thinking for yourselves). Well by the way of full disclosure, perhaps my thoughts were biased. This is because I don't have any "skin in the game." I have not invested so much as a penny in the stock market for the last four plus years. Now perhaps this was a prudent decision, in hindsight of course. So you are right, I don't care about the market perhaps as much as you - its not my money loosing value...right.
Now in my defense, I have had money in the market before, during and after the Dot Com bubble bust. I lost half the value in my portfolio.
Also, I do care about what happens on Wall Street and Main Street. I am a business student who, one day, would like to be an entrepreneur and own my own business. To entrepreneurs easy credit from Wall Street is a heaven sent, not to mention Main Street with excessive amounts of disposable income.
My stance has not changed: people make mistakes, so don't "tie the noose" yet.

What Has Main Street Done For You?

Minions! Before we begin today, let us define a few things:
Main Street = the stereotypical neighborhood drive, also used as the stereotypical American working family.
Wall Street = the stereotypical securities trader (hedge fund manager, derivatives trader, etc.) but is not limited to a single exchange market (America: NYSE, NASDAQ; London: LSE; Moscow: MICEX; Korea: KRX; Hong Kong: HKEX; to name a few), also used for the stereotypical owner of company or high level executive (CEO, CFO, corporate boards, etc. ["fat wallets"]).

Let’s begin.
Other than allowing the creepy old man across the street move in, who sits on his porch all day staring at your house, what has Main Street done for you? Yeah sure, it has given you a home, a roof over your head, shelter from the cold - oh wait, I'm sorry, Wall Street did that for you. Odds are they built your home, provided the materials that keep you warm at night, they provide your electricity, offered you enough money so that you can purchase that home of yours, and the list goes on.

Minions, it’s time we to cut Wall Street a little slack. Sure, they have had their blunders; including this giant credit one (which might I add started on Main Street). We must not forget how interconnected our lives are with Wall Street, they depend on us and we depend on them. In fact, I'll give you four examples: 1) Try to find an automobile maker in the market place that is not traded on Wall Street. 2) Blogger, the blog provider of this very blog, is owned by Google - a publicly traded company with a CEO with a "fat wallet." 3) Must you forget that you have a checking account, or a savings account, or heaven forbid a 401k, IRA, or Pension Fund. Yes, my minions, you are contributing to the very fat wallets that you despise so much. 4) Perhaps a publicly traded company has been generous enough to employ you in their vast empire of money.

So why do you despise them? Is it because the entire financial market made some risky bets and now your mutual fund values are half what they used to be? Sorry, I don't know if you got the memo, but mutual funds are a giant collection of stocks. Stocks are inherently risky, that is why you invest in such a large assortment of stocks when you invest in a mutual fund - to minimize that risk. You have earned such a nice 12% yearly reward over the past one hundred years or so for one simple reason: the more risk the investment the more they have to pay you to convince you to wade in the water of risk. However, mutual funds are not 100% risk free, especially when the entire world economy goes into the crapper (as we’ve seen).

I have one more thing to say about your retirement savings in the form mutual funds, in all its many letters and numbers (including: Roth IRA's, IRA's, 401(k), 403(b), etc.): as you put money into the mutual fund you are in fact buying stocks in each of those individual companies. By doing this you are literally an owner of the company, you are now the fat wallets that benefit when the company does well.

Minions, you may live on Main Street, but you rely on Wall Street more than you know. So lets stop mudslinging and starting thinking of a fix.

I Have Arrived

Please, do not fret; I have arrived to make your life a little less cluttered than it was the day before. Now you may enjoy one less direct human interaction, replaced by one more feed with direct computer input into your frontal lobe. From here on out I will be your voice of reason. You will no longer need to think of future consequences of your actions, for I will present them to you. Choices between good and bad options will be clear as glass, for I will choose them for you. Those who understand little of this existence, I will be your guide. Join my minions as we explain the world.