This is really the critical point. According to the standard textbook model, an increase (or a decline) in the labour income of a given individual should be interpreted as a rise (or a fall) in his or her marginal product, i.e. his or her contribution to total economic output. That is, if Mr Smith's wage rises from $30,000 to $50,000, then it must be that Mr Smith has produced $20,000 of extra economic output. The beauty of the market system is precisely that the increase in Mr Smith's wage should in principle correspond to the creation of new economic value and well-being, and is not obtained at the expense of anybody else (i.e. even with fully selfish economic agents there is no externality on others that is not being internalised by the price system). This textbook model probably provides an (approximately) accurate description of 99% of the labour market. However it is extremely naïve—to say the least—to imagine that it adequately describes the pay determination process at the very top end of the labour market. Assume that the CEO of AIG or GM manages to get an increase in compensation, say a rise from a $5m to a $10m total annual compensation. It is truly heroic to conclude from this observation that his or her contribution to AIG or GM output has increased by $5m, and that the total output of AIG and GM has risen by that much. There is tremendous evidence showing that the invisible hand of the market simply does not work in this very peculiar segment of the labour market, and that top executives will keep setting their own pay to the highest possible levels (with no connection whatsoever with their marginal product, which nobody can properly estimate) as long as they are not prevented to do so. Historical evidence suggests that highly progressive taxation on very high incomes is the most efficient way to achieve this goal.
This from Professor Thomas Piketty in his Economist debate with Cato Institute's Chris Edwards about instituting high (like 80% marginal tax rates) on incomes over a couple million dollars. It's a good summation of the back and forth that's been happening among policy wonks over how to regulate executive pay.
In this paragraph, Piketty puts his finger on the central perceived problem with paying CEOs a lot of money -- they don't produce value equal to what they earn. But what I haven't seen anywhere is much discussion of the reasons for setting salaries beyond a worker's marginal product, and there are a lot of other reasons.
Most relevant for CEO pay is the way someone else's pay -- someone above me in the corporate hierarchy -- can affect how hard I work. When I am making a decision about how much effort to expend in the current period, I'm balancing the cost of my effort against the benefit I get not only from my current salary, but also from the improved probability of being promoted, and the concomitant salary boost. So if I'm an Executive Vice President at a Fortune 500 company competing with five other EVPs and innumerable outside candidates to become the next CEO of the company, the CEO pay package could incentivize me to work harder to win that promotion. Without that incentive, you may have to pay me more. Paying me and my five other competitors more may actually cost you more than what you saved by paying the CEO less. And it's not that you're paying the CEO for her work -- some of her pay is just to incentivize me.
Obviously, this effect may not explain all big CEO pay packages, but it's at least worth thinking about, because if you don't, you're really not thinking about the problem in a complete way, and could end up misclassifying good corporate policy as bad, or criminal.
To me, big CEO pay packages are not a root problem, but a symptom of weak corporate governance. If we could be reasonably certain that a company's board was truly independent and their CEO was still making a ton of money -- more than they earn themselves -- then we could be reasonably confident that the company had other good reasons, like providing incentives to others within the organization.
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