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Innovation

The secret to paying CEOs more fairly

Purdue University researchers gave economics a scientific make over. Using mathematical equations, the researchers could show that free markets for labor can indeed pay executives more fairly.
Written by Boonsri Dickinson, Contributing Editor

"Fair" pay is relative, of course. It depends on who you ask.

Warren Buffett gets paid pretty fairly.

As CEO of Berkshire Hathaway, Buffett earned $200,000 in 2008. Now, assuming his lowest paid employee made $25,000, his pay ratio was 8-to-1.

Generally, a CEO of a company should be making 8 to 16 times the amount of the lowest employee.

That would be fair.

What isn't fair is how some CEOs make 344 times the salary of their lowest employee. Perviously, Purdue researchers found that 35 top CEOs were getting paid 129 times the amount of what would be considered fair. However in the 1970s, the pay was more like 40-to-1.

In a new study, the same Purdue researchers applied the laws of nature to economic theory in a quest to find a fair way of compensating executives.

Meet Venkat Venkatasubramanian, a Purdue professor of chemical engineering. He treats the movement of people like molecules and he does a darn good job of mixing physics with economics.

Enter econophysics.

Okay, so what the heck is econophysics?

It uses statistical teledynamics to suggest a new way of paying people for their labor. And all of this boils down to entropy.

In science, entropy measures disorder and uncertainty. But when applied to economics, it can also measure fairness.

When the marketplace isn't corrupt, people can operate like gases in a chemical equation. Under the most ideal situations, free markets can support fair compensation plans.

The equation known as the Boltzmann distribution for ideal gases can measure how molecules flow at different energy levels and how the molecules achieve equilibrium. But when the same principles are applied to economic theory, they can predict fairness.

"We are generalizing concepts from statistical thermodynamics - the branch of physics that describes the behavior of gases, liquids and solids under heat - to analyze how free markets should perform ideally," Venkatasubramanian said in a statement.

The study found that fairness is critical to a normal functioning free market economy — challenging conventional wisdom, which just assumed the free market only wanted efficiency and disregarded the importance of fairness.

What's more, the inflated pay for executives is an American phenomenon. In Japan, the executives get paid 11-to-1 and in Britain, they get paid 22-to-1.

Will the CEO valuation bubble continue to increase or will it go bust? Only time will tell.

But at least now, Venkatasubramanian has a formula that can make the executive pay scale a little more fair. "Well, it turns out that the same concepts and mathematics used to solve problems in statistical thermodynamics and information theory also can be applied to economic issues, such as the determination of fair CEO salaries."

The more CEOs get paid, the more mean they get!

This is a lose-lose situation for most of us. But who said life is fair, anyway?

Photo: Purdue News Service file photo/Andrew Hancock

The full research paper is here.

This post was originally published on Smartplanet.com

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