Xavier Gabaix, a Harvard economist who is now on the Princeton Faculty, explains why CEO pay has increased so much:

This paper develops a simple equilibrium model of CEO pay. CEOs have different talents and are matched to firms in a competitive assignment model. In market equilibrium, a CEO’s pay changes one for one with aggregate firm size, while changing much less with the size of his own firm. The model determines the level of CEO pay across firms and over time, offering a benchmark for calibratable corporate finance. The sixfold increase of CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large US companies during that period. We find a very small dispersion in CEO talent, which nonetheless justifies large pay differences. The data broadly support the model. The size of large firms explains many of the patterns in CEO pay, across firms, over time, and between countries.

What does this all mean? Harvard economist Greg Mankiw explains:

In Xavier’s view, CEO’s are earning the value of their marginal product. Top CEOs are paid high salaries because they are directing the fortunes of large enterprises, and even a small amount of extra talent is worth a lot.

Some people on the left have suggested that high CEO pay is a reflection of poor corporate governance, which allows CEOs to, in effect, steal value from shareholders. Xavier tests for this possibility using a measure of corporate governance and concludes, “Poor governance does increase CEO pay, but the effect seems small.”

The paper can be found here. More commentary by Mankiw can be found here.