Incentives, Agency Theory, and Executive Compensation

It’s been said that “an economist is a man who states the obvious in terms of the incomprehensible.” Cute joke, but of course pretty far off-base. Well, at least the part about “the obvious” is off-base. Economists are often able — typically through careful attention to relevant, quantifiable factors — to figure out what’s going on in complex situations, including some situations in which common sense either has little to say, or is notoriously unreliable.

Case in point: the two economic studies described in this story, from The Economist: Firmly hooked (Is it good if bosses feel strongly for the firm?)

Getting bosses to act in the best interests of a company’s shareholders has long been one of capitalism’s trickiest problems, identified early on by Adam Smith. In “The Wealth of Nations” he worried that “Being the managers of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own.” In the 1920s, Adolph Berle and Gardiner Means followed up on the problems of separating ownership from control in their classic study, “The Modern Corporation and Private Property”. From the 1970s, this dilemma acquired its own branch of economics—agency theory, which studied the problems that can arise when “principals” (ie, shareholders) hire “agents” (executives) to run their firm….

The article goes on to explain the findings of two studies, both by economists, that examine a couple of apparently common-sense assumptions. First is the assumption that short-term incentives drive CEOs to make stupid decisions, and that longer-term incentives would work better. The second is the idea that strong self-identification of CEOs with the firms they run makes CEOs more likely to make decisions that are in the best interest of the firm. Lots of people probably find both of those theses plausible. But are they true? It takes an economist to figure that out. So, read the article.

The more general point is that you really can’t say much sensible about a topic like executive compensation without understanding at least the basics of economic concepts such as agency theory. I mean, feel free to have an opinion; but be prepared for that opinion to fall flat when faced with a structured analysis of facts.

(While we’re on the topic of economic literacy, I’d like to suggest that pretty much everyone should read this book, by Joseph Heath: Filthy Lucre: Economics for People Who Hate Capitalism. The sub-title of the book is actually somewhat misleading: it has nothing to do with hating capitalism. The first half of the book is about economic myths of the right; the second half is about economic myths of the left. It’s smart, well-informed, and clear. A good read.)


Thanks to PY Néron for alerting me to the Economist story.

1 comment so far

  1. DarryleHuffman on

    I have been doing some thinking about executive pay. If I were a Hindu then I would be on the Path of Pleasure. According to the Hindu this is one of the four legitimate paths to trod. To the Hindu then executives are to be helped in this path. As one looks at the payscale one should also consider whether the executive is worth what is given to him. But if he is not doing his work then according to Bhagavad Gita “Renunciation of obligatory work (or duty) is not proper. The abandonment of duty is due to delusion, and is declared to be Taamasika Tyaaga. (18.07)
    If he is not profitable then let him go on his delusional way but if he is profitable then rerward him or her thier worth.


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