Few debates in corporate finance are as persistent—or as politically charged—as the one over executive compensation. In 2024, the U.S. Federal Trade Commission moved to ban noncompete clauses for most workers, citing concerns about labor market distortions, while allowing existing noncompetes for senior executives to remain in force. Although the rule is currently on hold, this distinction reflects more complex concerns surrounding noncompetes for corporate executives than average rank-and-file workers. Furthermore, CEO pay packages remain a flashpoint for shareholders, regulators, and the public alike. But beneath the outrage lies a genuine puzzle: is high executive pay an efficient outcome of competitive labor markets, or is it evidence that corporate governance has broken down?

The conventional debate offers two main explanations. The “shareholder view” holds that high CEO pay is simply the market price of scarce talent: boards compete for exceptional executives, and exceptional executives command exceptional wages. The “managerial power view” holds that pay is high because CEOs have captured their boards, exploiting weak governance to extract rents from shareholders.

A third view is both less intuitive and more troubling. Even when boards are fully independent and CEO labor markets are perfectly competitive, executive pay can still be systematically too high, too front-loaded, and accompanied by insufficient turnover. The problem is not corruption or captured boards. It is a coordination failure embedded in competitive markets themselves.

The Levers to Motivating CEO

To understand why, consider the tools boards use to motivate their chief executives. Boards cannot directly observe everything a CEO does—whether they are pushing hard on the most important priorities, making sound long-term decisions, or managing risk appropriately. CEOs must therefore be given financial incentives to act in shareholders’ interests.

Boards address this through instruments. The first is deferred pay: promising future compensation contingent on good performance. This acts as a “carrot,” giving CEOs a stake in the long-term outcomes of their decisions. The second is the threat of termination—firing the CEO after sustained poor performance. This acts as a “stick,” deterring shirking or value-destroying behavior.

The effectiveness of the stick depends critically on one thing: what happens to the CEO after they are fired? In the most common case, when a fired CEO faces a long spell of unemployment or a significant pay cut at their next position, termination is a powerful disciplinary tool. However, in instances when fired executives can land a lucrative position elsewhere, the threat loses much of its bite.

The Hidden Externality

Here is where competition creates an unexpected problem. When a board designs a generous compensation package to attract, motivate, and retain its CEO, it not only rewards its own executive—it also improves the outside option for every other CEO in the market. By raising expected compensation in new positions, any one firm’s pay decision makes it easier for executives at other firms to land well if they are dismissed. Each firm’s pay package inadvertently weakens the disciplinary power of termination across the entire market.

This is a textbook externality: one firm’s private decision imposes a cost on others. No individual board accounts for this spillover when designing its compensation package. Each board rationally takes the labor market as given and chooses the best contract for its own situation. The cumulative result is that all firms end up in a worse equilibrium—one in which termination threats are systematically less effective than they would be under coordinated pay levels.

Too Much, Too Soon, for Too Long

Once termination loses its bite, something has to fill the gap. Boards must rely more heavily on carrots—direct compensation, as rewards for good performance—to motivate their executives. This produces three interrelated distortions.

Too much. Without a credible termination threat, boards must offer significantly higher pay. The carrot must be larger to do the work that the stick no longer does.

Too soon. Executives are impatient, and the cost of promising very large future rewards grows with the size of the promise. Boards therefore front-load payments rather than deferring. CEOs receive too much of their pay upfront and too little tied to long-term outcomes.

Too long. With termination rendered less effective as an incentive device, boards are also less willing to pull the trigger on dismissal after poor performance. Underperforming executives remain in their roles longer than is optimal for shareholders.

These distortions are not the consequence of bad governance. They are the equilibrium outcome of individually rational behavior in a competitive market.

Who Is Most Affected?

The severity of these distortions varies across industries. They are most pronounced in sectors where executives are highly mobile—where managerial skills transfer easily across firms and dismissed CEOs can quickly secure attractive new roles. Technology and financial services come to mind. In these sectors, the outside option for a fired CEO is lucrative, the disciplinary power of termination is small, and pay must be high and front-loaded.

Distortions are also more severe in industries where replacing management is particularly disruptive: where search costs are high, institutional knowledge is hard to replace, and leadership transitions impose significant costs. In such environments, boards are doubly reluctant to use termination. Sectors with more volatile or harder-to-observe performance face a more acute version of the problem and hence more severe overcompensation.

What Can Be Done?

A benevolent social planner with the power to set compensation market-wide would choose lower pay than competitive markets produce. By coordinating to keep outside options modest, it would restore the disciplinary bite of termination—making it possible to incentivize executives at lower cost, with more deferral and more disciplined turnover. Such a pay cut would benefit shareholders in aggregate, even though no individual firm would have any incentive to cut pay unilaterally.

The noncompete clause is one contractual mechanism that hurts executives’ outside options. By restricting executives from immediately joining rival firms after departure, noncompetes limit the attractiveness of the outside option and can restore some of the bite of termination threats. This suggests a new economic rationale for a provision often regarded as anti-competitive. It also highlights that the trade-offs behind the FTC’s intended ban are more complex for senior executives, and that the case against no-compete clauses is stronger for rank-and-file employees than for executives.

That said, noncompetes carry their own cost: they restrict firms’ ability to recruit outside talent. The optimal policy therefore involves a genuine trade-off rather than a simple prescription. More broadly, some form of coordination—whether through regulatory guidance on pay structures, norms around deferral, or collective action by institutional investors—could improve outcomes in ways that individual governance reforms cannot.

Figure 1. The Compensation Externality: A Feedback Loop. Competitive pay decisions by individual firms improve the outside options of all executives, weakening the disciplinary threat of termination market-wide. A social planner who coordinates pay levels can break the cycle.

A Wider Lesson

The analysis focuses on CEO compensation, but the underlying logic extends further. Whenever incentive contracts rely on punishments—termination, demotion, loss of future career opportunities—their effectiveness depends on outside options that are themselves shaped by market-wide behavior. Even in a competitive labor market, individually optimal performance-based contracts can generate economy-wide spillovers that weaken discipline and raise costs for everyone.

The takeaway for policymakers and practitioners is both counterintuitive and important: competition, on its own, does not guarantee efficient executive compensation. Even a well-functioning, transparent market for executive talent can produce systematic overcompensation—not because of bad actors, but because of the structure of incentive provision in equilibrium. Understanding this coordination failure can help inform more effective governance and compensation design.