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Big fish, little fish — choose your pond

Company size, design and market structure correlate with executive salaries

Based on the research of Professor B�rd Harstad

By Agust�n Casas

  Bard Harstad
  B�rd Harstad  Photo © Evanston Photographic

Insight insights: selections from the Kellogg online faculty research digest

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Just as the popularity of star musicians or athletes determines their earnings, managers' reputations are pivotal in the design of their contracts and compensation, writes Assistant Professor B�rd Harstad. But what determines a reputation's value and how is it created? Companies judge potential new managers on what is known about their past performance. However, not all jobs are equal for a manager desiring to establish a stellar reputation — visibility of individual effort is of utmost importance and is influenced by a company's organizational structure.

Harstad writes that "[w]hile the organizational design determines the allocation of blame and fame within the firm, the value of a good reputation depends on the market structure." By combining a model of the market with a model of organizational design, he shows how changes in the former drive changes in the latter.

In Harstad's model, a manager's talent determines the cost of production under her supervision: Better managers are able to produce more at a lower marginal cost. Moreover, when competition gets tougher and the market gets "thicker" (e.g., the number of potential customers increases), the most cost-effective firm captures larger market share: Better managers reduce costs and outfox the competition, and firms are willing to pay much more for them.

As the competition for market share increases, top managers' salaries tend to be larger, providing an additional incentive for executives to gain good reputations. Young managers with unknown talent are willing to accept a lower wage when offered an opportunity to work in a position with high exposure. Firms whose organizational structure allows such exposure can afford to pay their current managers less.

Firms' organizational designs vary in, for example, task distribution and transparency. Tasks may be centralized in one person or distributed among many. A firm can be transparent, with everyone's performance visible, or non-transparent, in which only aggregate performance is discernible.

Imagine a group of high school students making a Web site where they all write reviews of their favorite computer games. One of them, Jenny, writes particularly well. At first their audience is small, consisting mostly of friends, and Jenny might not even bother to sign her reviews. But once the site attracts more visitors, Jenny would likely prefer to have her name known. The Web site could make her participation even more visible by including a prominent link to "New Reviews by Jenny," thus enhancing transparency.

Harstad analyzes decentralization in transparent and non-transparent firms by building a model in which two managers deal with two different tasks. In non-transparent firms, both managers share the reputation from the success or failure of the entire firm. This makes it less likely for one of them to achieve a "superstar" reputation. As competition increases and the market grows thicker, an extremely good reputation becomes relatively more valuable. These firms then find it profitable to centralize control in one manager, as she is able to take credit for the company's overall success and is therefore willing to accept a lower salary for such an opportunity. In transparent firms, where individual managers' performance is observable, the inverse is true: More competitive markets encourage decentralized control, as they are able to offer opportunities to create potentially stellar reputations for several young managers at the same time.

Returning to the Web site example, suppose that it expands into two new game genres, flight and cooking simulators. For that, it has two new reviewers: Joe and Mary. It is possible to put, say, Joe in charge of describing controls and Mary in charge of evaluating graphics in each review. Alternatively, Mary could review flying and Joe could review cooking simulators. In the second option, the quality of each writer is more discernible, and the chances of discovering a new Jenny are high, making this option more attractive for Joe, Mary and the Web site when the market is big and the competition fierce. Thus, firms switch from "unitary" to "multi-divisional" form in such circumstances.

Harstad's model also explains why tough competition leads to higher management turnover. When the market becomes tougher, excellent reputations are pivotal, so moderately good, experienced managers are replaced with younger ones more likely to achieve star status.

Agustn Casas is a doctoral student in the Department of Economics, Weinberg College of Arts and Sciences, Northwestern University.

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