Compensation and Incentives: Practice vs. Theory

Abstract

A thorough understanding of internal incentive structures is critical to developing a viable theory of the firm, since these incentives determine to a large extent how individuals inside an organization behave. Many common features of organizational incentive systems are not easily explained by traditional economic theory-including egalitarian pay systems in which compensation is largely independent of performance, the overwhelming use of promotion-based incentive systems, the absence of up-front fees for jobs and effective bonding contracts, and the general reluctance of employers to fire, penalize, or give poor performance evaluations to employees. Typical explanations for these practices offered by behaviorists and practitioners are distinctly uneconomic-focusing on notions such as fairness, equity, morale, trust, social responsibility, and culture. The challenge to economists is to provide viable economic explanations for these practices or to integrate these alternative notions into the traditional economic model. ECONOMISTS HAVE GROWN INCREASINGLY interested in the theory of the firmin recent years.1 These efforts have focused on the relations between markets and hierarchies, the influence of organization-specific assets, corporate governance systems, and the agency problems caused by conflicts of interest among the contracting parties that make up the firm. One of the more important, but least analyzed, factors affecting organizational behavior is the internal incentive structure which includes the management of human resources in general, and compensation policies in particular. A thorough understanding of internal incentives is critical to developing a viable theory of the firm, since they largely determine how individuals behave in organizations.Our economic understanding of internal incentive structures is far from complete. There has been an enormous amount of research in the economics of 593

Public Opinion and Executive Compensation

“…We include several measures of lagged firm performance, namely stock return, return on assets (ROA) and sales growth in year t − 1, since better performing managers will be better remunerated. We also control for the lagged firm sales, which has been used as a measure for firm size and complexity (e.g., Baker, Jensen, & Murphy (1988)), and for the lagged market value, which is a proxy for the present value of the firm's growth opportunities, since all these firm characteristics have been shown to influence CEO compensation (e.g., Murphy (1999)). 15 We control for the Bebchuk, Cohen, & Ferrell (2009) entrenchment index since powerful CEOs may extract more pay, as well as for the firm's stock volatility as it can mechanically drive the value of compensation, particularly the value of option grants.…”

Paying with Self-Chosen Goals: Incentives and Gender Differences

“…Empirically, a large number of studies have shown that bonuses are positively correlated with employees' performance (Groves et al, 1994;Baker et al, 1988;Banker et al, 2000;Enis, 1993;Jones and Kato, 1995;Kahn and Sherer, 1990). Furthermore, beyond providing monetary incentives, experiments also show that a bonus can also trigger gift-exchange considerations and induce some agents to expend more effort than under an incentive contract (Fehr et al (2007)).…”

Relationship between CEO Pay and Firm Performance: Evidences from Malaysia Listed Firms

“…These include the internal governance structures such as smaller boards (Yermack, 1996), a higher degree of board independence (Rosenstein and Wyatt, 1990) and CEO ownership (McConnell and Servaes, 1990). As a major explanation for CEO pay (e.g., Baker et al, 1988;Jensen and Murphy, 1990), agency theory has been challenged by the corporate compensation practices (Mintzberg, 2009) and it has also been criticize for its inability of cross-country difference (Haubrich and Popova, 1998; Bruce et al, 2005; Filatotchev and Allcock, 2010).…”