Before getting to the evidence, it is worth considering what executives do in general, and how they get compensated.
Chief executive officers, chief financial officers and other C-level executives make important strategic decisions. If they act wisely, their companies are more likely to succeed and earn bigger profits. Oil and gas executives, for example, make critical decisions about where, when and how much to invest.
In many industries, the decisions executives make can also impact the prices their companies can charge.
For example, Apple’s ability to charge $1,000 for an iPhone X reflects in part the skills of CEO Tim Cook and other Apple executives at developing a desirable product and marketing it. But in a global commodity market like oil, executives have zero control over price. No matter how talented CEOs are, or how hard they work, they can’t singlehandedly make oil prices rise.
In economic parlance, hiring an executive is a principal-agent problem. The board of directors, the principal, hires an executive, the agent, to act on its behalf. The principal wants the agent to work hard and to make good decisions, but it is hard to measure this effort. Instead, executive compensation typically includes incentives like bonuses, stock options and other forms of pay, designed to align the interests of the executive with the interests of the company.
Tying compensation to luck just makes compensation more volatile, which in turn makes both companies and executives worse off. Holmstrom and others have found it easy to remove luck from compensation by, for example, basing compensation on a company’s performance relative to its competitors.