A New Perspective on Incredible Growth of CEO-worker Pay Gap: Risk Aversion on Potential Loss of Firm Value

Abstract

Facing the incredible growth of CEO-worker pay gap (CWPG) in business practices across the world, the traditional principal-agent theory and the tournament theory cannot explain it to a satisfied degree. In order to deal with such a research gap, a new perspective named risk aversion is proposed to investigate the forming mechanism of CWPG by building a theoretical model. The model proves that the firm determines CEO compensation level according to the potential loss of firm value that may be produced by the CEO with under-utilizing or misusing his/her discretion, which depends on the relative level of CEO compensation to the average CEO compensation in the professional manager market, while the firm sets employee compensation level according to his/her marginal outputs. The repeated dynamic game among all the CEOs and the firms in various industries would naturally make the average CEO compensation level increase rapidly, while the increase rate of the employee’s marginal outputs is much slower. In this way, EWPG would inevitably and reasonably experience explosive growth.