This is “Manager Motivation and Executive Pay”, section 5.11 from the book Managerial Economics Principles (v. 1.0).
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In businesses where the manager is not the owner, there is another manifestation of the principal-agent problem. For example, in a typical corporation, the owners are stockholders, many of whom are not involved in the actual production activities. The board of directors hires executive management to act as the agents of the shareholders, who are the principals in this context. The intent of the arrangement is that the executives will manage the corporation in the best long-term interests of the shareholders. However, the executives, though they may own some of the corporation’s shares, are largely rewarded via salaries, bonuses, and other perquisites. Structuring executive contracts that both motivate the executive and represent the owners’ interests is a challenge.
The executives in corporations are often paid highly, certainly well above the opportunity cost of their labor in a nonexecutive setting. There are multiple theories for these high executive salaries. One argument is based on economic rent, namely, that talented executives are like star athletes and art performers, being in relatively short supply, so corporations must pay well above their opportunity cost to have their services.
Another argument for high executive pay is that they need to be not only compensated for their effort but rewarded for the value they create on behalf of the owners. So part of the higher salary is a share of the profits resulting from their execution of management duties.
A third argument for high executive salaries is that firms must often take significant risks to succeed in competitive markets and uncertain conditions. If the firm fails or falls short when its performance is assessed after the fact, the executive may lose his job. In response to this, the executive may avoid bold moves that have a significant risk of failure. In paying an executive highly, the executive is compensated for the additional personal risk he assumes by being willing to take reasonable chances that the corporation must tolerate.
Another interesting argument for high executive pay is called tournament theoryThe idea that paying a CEO well beyond what is justifiable on the basis of the individual's contributions creates an incentive for other executives on the team to put in extra effort in order to have a chance at similar rewards in the future..See Milgrom and Roberts (1992). This applies to large enterprises with a sizeable team of executives, with a highly paid chief executive officer (CEO), along with several other vice presidents who are in line for consideration to become a future CEO. By paying the CEO generously and well beyond what is economically justifiable on the basis of the CEO’s contributions per se, there is a strong incentive for the other executives to put in extra effort so they will become that chief executive, with all the high pay and perquisites, in the future. From the perspective of the shareholders, the gain from those collective extra efforts is worth the high salary to the last winner of the CEO “tournament.”