Priceless: The Myth of Fair Value (and How to Take Advantage of It) (36 page)

The effect of oxytocin in the ultimatum game is so dramatic that, I suspect, few researchers doubt it could in principle affect business decisions. That part of the claim isn’t necessarily crazy. What
is
crazy is the spray bottle. In Zak’s experiments, 40 international units of oxytocin was sprayed directly into the nostrils. Good luck explaining that to the client from Buffalo. The Liquid Trust marketing implies that you can use it like a botanica’s money-drawing spray. Well, not really. Oxytocin isn’t volatile. Spritzing yourself or a thank-you note isn’t going to have much effect on anyone else. Most of the recommended uses would expose the user more than the unsuspecting “victim.” Even if the spray did work, the user would be the one willing to give away the farm.

In 1997 a General Electric subsidiary made an uncharacteristically generous wage offer. Jerry Seinfeld, star of NBC’s hit sitcom, announced his intention to quit. He was making an unprecedented $1 million an episode. NBC responded with an offer of $5 million an episode if only Seinfeld would do one more season.

The offer penciled out. NBC was earning something like $200 million a year from
Seinfeld
advertising and syndication. That meant that each of a season’s twenty-two episodes brought in about $9 million profit. Rather than forgo that windfall, the network was willing to be hyperfair—to surrender over half of its profit to the star.

Seinfeld passed. He stood firm on his intention to quit while his show was still funny. Inevitably, word of the NBC offer leaked out. It was soon all over the entertainment news. The network brass must have hoped that everyone would appreciate that
Seinfeld
was a special case and that a blue-sky $5 million offer did not set a precedent.

Actors at all levels of the TV food chain thought otherwise. Over the next few years, star—and sidekick—salary demands escalated as never before. In 2002, the leads of
Friends
collectively bargained their way to $1 million per episode. That was $1 million
each
for the six “friends.” Ray Romano was making $800,000 an episode for
Everybody Loves Raymond
, and
Frasier
’s Kelsey Grammer was the leader with $1.6 million an episode. James Gandolfini shut down
The Sopranos
after he found out he was only making as much money as the housekeeper on
Frasier
.

What is a TV star worth? For that matter, what’s a construction foreman,
ballplayer, or U.S. president worth? Labor economics treats salaries as the outcome of a reasoned trade-off between the supply of talent and the demand for it, or between the desire for leisure and the desire for money to buy things. More recently, behavioral economists have assembled a case that salaries can be as arbitrary as prices. “Wage earners, we suspect, do not have a good idea of what their time is worth when it comes to a trade-off between consumption and leisure, and do not even have a very accurate idea of what they could earn at other firms,” wrote Dan Ariely, George Loewenstein, and Drazen Prelec. “In other words, workers care about changes in salary but are relatively insensitive to absolute levels or levels relative to what comparable workers make in other firms.” They note that the coherent arbitrariness of salaries is tacitly recognized in an old one-liner: A wealthy man is one who earns $100 more than his wife’s sister’s husband.

The inflation-adjusted pay of top earners has varied fantastically. Consider CEOs. The Economic Policy Institute calculates a number of widely followed ratios. According to the institute, in 2005 America’s top executives were earning about 1.8 times as much as their counterparts in the United Kingdom, and four times as much as Japanese CEOs. Another benchmark is the ratio of American CEO pay to that of an average worker (see below). In 2007, this stood at 275. It’s changed a lot. It was around 50 in the Reagan era and 25 in the 1960s.

In the early 1990s, Senator Ted Kennedy led a chorus bemoaning the rise. Average workers had just about kept pace with inflation in the previous generation, while CEO pay had about doubled. The U.S. Congress responded with a 1993 law eliminating certain tax deductions above the million-dollar salary threshold.

Instead of reining in CEO salaries, the million-dollar threshold seems to have functioned as an anchor. The law broadcast to the more backward parts of the corporate world that seven-figure salaries were
possible
(so why not
me
?). In 1989, four years before the law, that ratio stood at 71. By 2000 it had surged to around 300. “In the hall of fame of unintended consequences,” said Nell Minow of the Corporate Library, a management oversight group, “that has to rank right near the top.”

The class war between labor and management has opened a new front, between management and shareholders. In response to shareholder concerns about allegedly insupportable CEO pay, the Securities and Exchange Commission issued new disclosure rules on executive compensation. “I absolutely thought [pay] would go down because the disclosures would be so embarrassing,” recalled Graef Crystal, an architect of those disclosure rules. “But it turned out that when somebody is hauling in $200 million, he’s not embarrassable.”

As CEO of Apple Inc., Steve Jobs takes a salary of $1 a year. His real compensation comes mainly in the form of vested restricted stock. This came to $647 million in 2006, or about 11.6 percent of Apple’s $5.60 billion profit. Apple was forking over a tenth of everything it made.

The “Lone Ranger theory” asserts that the CEO is primarily responsible for a company’s stock market value. It is not too hard to believe that with Jobs and Apple; the two are almost synonymous in the public mind. In 2008 a succession of rumors, conference calls, and leaks about Jobs’s allegedly failing health hammered Apple’s stock value. Some statistical studies purport to find a strong correlation between chief executives and stock value, even for the garden-variety CEO less in the public eye than Jobs.

Accept the Lone Ranger theory, and almost any CEO paycheck becomes conceivable. The quintessential example is Jack Welch. In his twenty years at GE, the company’s market value zoomed from $14 billion
to $500 billion. “What’s a CEO worth for such an achievement?” asked George Mason University economist Walter E. Williams recently. “If Welch was paid a measly one-half of a percent of GE’s increase in value, his total compensation would have come to nearly $2.5 billion, instead of the few hundred million that he actually received.”

The trouble with the Lone Ranger theory is that it’s tough to say how much of the rise was due to Welch and how much to (for lack of a better word) luck. Inflation alone would have doubled GE’s value from 1981 to 2001. Presumably Welch doesn’t deserve credit for that. Nor does he deserve much (any?) credit for the bull market that increased S&P stocks ninefold in that time frame. Legacywise, Welch had the incredible fortune of retiring at just the right time, five days before 9/11. GE owned insurance companies that lost $600 million in World Trade Center claims and billions over the next few years. But that wasn’t Welch’s problem, nor were the miserable markets of the 2000s.

Under Welch’s successor, Jeff Immelt, GE’s market value has dwindled to about $96 billion. You might say Immelt is the Bizarro Jack Welch. On his watch, over 80 percent of stockholder wealth vanished into thin air. By the Lone Ranger theory,
it’s all Immelt’s fault
.

Now of course that’s ridiculous. Immelt is a talented and hardworking manager, some say as good as Welch was. Immelt probably wouldn’t have much patience with the proposition that he should be reimbursing GE shareholders for their losses rather than drawing a salary. He would insist the decline in GE’s stock value was bad timing or bad luck. How much of Welch’s success was good luck? Is there any way of telling?

Appearing on MSNBC’s
Hardball
in 2006, Welch invoked the corporate world’s favorite populist analogy. CEOs are like baseball players, Welch said. “Should there be a ratio with these people? Everybody is out with their checkbook and wallets trying to get somebody, and agents are having a ball. They’ve got three weeks. No different, Chris.”

Host Chris Matthews helpfully recalled a famous Babe Ruth quip. Asked why he earned more money than the president, the Babe supposedly replied, “I’ve had a better year than he has.”

Actually, baseball salaries are just as mystifying as CEOs’. In 1922 Babe Ruth became the first player to make $50,000 a year. That’s about $640,000 in today’s dollars. In 2000 Alex Rodriguez signed a ten-year
contract giving him over $25 million a year. When you adjust for inflation, A-Rod is making 49 times what the Babe was. Why? It can’t just be the steroids. Neither Rodriguez nor baseball has nearly the pop culture footprint that Babe and the game once had. Since the 1920s, the U.S. population has increased (by a factor of about 3), and television has broadened the baseball audience and ad revenues. Still, there’s an awful lot more ways to spend leisure time these days.

Suppose we take baseball salaries, adjust for inflation, and divide by Babe Ruth’s inflation-adjusted 1922 salary. Call the result the “Babe Ruth ratio.” The table shows that salaries have burgeoned even as baseball has become an ever smaller part of the sports and entertainment universe.

There is great coherence in wage structures. Major leaguers make more than minor leaguers, and Immelt makes more than his vice presidents, who make more than the guy making lightbulbs on the assembly line. It is less clear how arbitrary salaries are. We all like thinking that pluck prevails over luck and that “star” talent can turn around a ball club or a multinational corporation. But it’s tough to prove that, much less to put a price on it.

In practice, top salaries are left to the judgment of a few. The rest of us shrug and figure that the numbers can’t be too unreasonable. That’s not just supply and demand, it’s anchoring and adjustment.

Late at night, you’re flipping channels and see an infomercial for an amazing new product. It’s a little black box that, exactly once a year, spews out a crisp new dollar bill. It’s perfectly legal, the pitchman assures you, and you can spend the dollar any way you want. The box will produce a dollar this year, next year, the year after that, and so on—forever! How much would you pay for a product like that?

One way of evaluating the box’s worth is to imagine how you could spend a dollar a year. You could tip someone you don’t especially like for Christmas . . . supersize one fast-food order next summer . . . You will probably conclude that the box is worth paying at least a dollar for. You’ll recoup that the first year, and then afterward it will all be gravy.

You might also reason that the box is worth less than your current life expectancy in dollars, since that limits how many dollar bills you can collect. (For the record, the box keeps working after the original owner’s death, and you’re allowed to bequeath it to anyone you like.)

Your price for the box should have something to do with your capacity for delayed gratification. That is, you’re giving up some of your hard-earned money
now
, in the form of the purchase price, to enjoy a stream of earnings
later
. Someone who is focused on the present moment—the guy who’s always maxing out his credit cards—might not be interested in the box at all. Someone who looks at the long term might be willing to pay a relatively high price.

One thing is clear. There is no indisputable right price. Were you to do an anchoring experiment, you would probably find that you could
manipulate prices. Should the infomercial’s studio audience clamor to buy the box for $2, most viewers would probably accept that as a reasonable price. Should the crowd decide it’s worth $60, that would be reasonable too.