Agency Theory Is Used to Explain Executive Pay

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Agency theory has often been used by economists to explain executive pay. Both executives and shareholders may have divergent interests and risk profiles under agency theory. For instance, executives view their interest in profits as a bonus in contrast to shareholders that consider their interest to be dividends and capital gains. With divergent interests, executives may prefer to avoid risking company assets or resources to protect their jobs. That is, a risk that fails can put executives out of a job while shareholders only lose part of their portfolio. Risk-adverse executives may prefer to pay themselves excessive salaries rather than take on risks that could jeopardize the company or cause the loss of their livelihood. In contrast, executive may take excessive risks because their own money is not on the line. Because the average tenure for CEOs is less than five years, risk-adverse executives may emphasize short-term goals at the expense of the organizations long-term objectives.

Agency theory uses two mechanisms to influence executive behavior. The first is alignment of interest through incentive contracts designed to reward executives for creating value in the firm. Conversely, these contracts provide for only salary and benefits if their efforts fail to create value. The second is monitoring of executive actions through governance procedures to approve all major decisions and limit conflicts of interest.

Principal-agent model - This model assumes executives work to produce value for the firm in exchange for tangible and intangible benefits including financial compensation. Although many aspects of the principal-agent relationship are reflected in employment contracts, monitoring agents is limited to obser...

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...escalation and shareholder criticism, the compensation committees dilemma is whether to pay higher wages for top talent that could potentially increase company value or pay less for inferior talent that might reduce it.

d. Tournament models - This approach assumes that executives are drive by the job level, pay, and promotion opportunities as they compete across the corporate hierarchy for open positions. As executives move up in the organization, there are fewer and fewer chances for promotion. "At the highest rung of the corporate ladder, the probability of promotion to CEO is so small that a very high relative rate of pay is required to maintain an adequate incentive effect for senior executives operating just below [the] CEO level" (p. 25). Thus, high level executives require increased pay as they more up to offset the reduced probability for promotion.

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