A Structural Estimation of the Cost of Suboptimal Matching in the CEO Labor Market

Abstract

Using a structural model, I examine the distortionary effects of frictions in the CEO labor market. Firms experience productivity shocks over time and either outgrow or underutilize their incumbent CEO's talent, but keep their manager to avoid a switching cost. The decision to replace a manager depends on the magnitude of the cost and dispersion of CEO talent. I find CEO talent to be quite heterogeneous. Additionally, I estimate the switching cost to be 20% of the median firm's annual earnings. While reduced-form estimates of the switching cost serve as a lower bound on the reduction in firm value, they underestimate the overall effect which also includes the resulting inefficient firm-CEO matches. Using counterfactual analysis, the switching cost is estimated to decrease the median firm's value by 4.8%, four times larger than the reduced-form estimate. While firms experience an observable decrease in earnings when finally replacing CEOs, I find evidence of a considerable unobservable cost associated with the inability of firms and managers to be optimally matched in the cross-section.