Berkeley Program in Law and Economics

CEO compensation varies widely, even within industries. In this paper, we investigate whether differences in skill explain these differences in CEO Pay. Using the notion that skilled CEO's are more likely to continue prior good performance and to reverse prior poor performance, we develop a new methodology to detect if skill is related to pay. We find that highly paid CEO's are more skilled than their industry counterparts when firms are small or face few environmental constraints, expecially when there is a large shareholder and the the CEO has high incentives. By contrast, pay is negatively related to skill in large firms constrained by environmental conditions, expecially when there is no large shareholder to monitor management. We also examine CEO turnovers and show that the firm's post-turnover permormance is related to differences between the two CEO's pay levels. Finally, we find that a portfolio that invests in firms managed by highly paid CEO's and sells firms manages by poorly paid CEO's generates an annualized abnorman return of 8% between 1994-2001, but only in conditions when pay and skill are related.