Theories of the determinants of executive compensation likely sparked by the surge in executive pay since the mid1980s, the academic debate has proposed numerous theories addressing the determinants of executive compensation. We start by presenting data on the level of ceo and other top executive pay. First, as the traditional agency theory is not able to explain the level, composition, and evolution of executive compensation in china e. I am deeply grateful for the invaluable comments of al calnan, jim fischer, dani hart, paul horwitz, sung hui kim, carrie. Corporate executives have been receiving immense compensation packages specifically in the form of stock options. A modern primer alex edmans and xavier gabaix this article studies traditional and modern theories of executive compensation, bringing them together under a simple unifying framework accessible to the generalinterest reader. Corporate governance and executive compensation for. Introduction it is difficult to imagine a corporate law topic that has generated as much consternation, or as much academic research, over the last 20 years as public company executive compensation.
There are multiple ethical issues with executive compensation. In this lesson, well learn about some theories and strategies of. This approach was the foundation for the calls from economists for companies to have. Many of its propositions about executive compensation are made with. Economic and behavioural theories in compensation economics essay. Bhattacharyya 2007 develops a model in which compensation contracts motivate highquality managers to retain and invest firm earnings, while lowquality managers are motivated to distribute income to shareholders.
Theories of compensation in order to understand which components of remuneration are more effective, we need to understand the conceptual framework or theories or employee remuneration. By developing a reputation for high level of pay, firms will attract the largest pool of talent to their organization. Executive pay is a major issue in the corporate governance debate. Three such theories are reinforcement and expectancy theories, equity theory and agency theory. The handbook of the economics of corporate governance. We find that the sensitivity of ceo pay to firm performance decreases with the variance of performance. Executive compensation is a rich, complex, and controversial topic. The case of chinese stateowned enterprises abstract. Thus, stewardship theory holds that performance variations arise from whether the structural situation in which the executive is located facilitates effective action by the executive. The issue of tournament theory, which was first mentioned by edward lazear and sherwin rosen in 1981 shen, gentry and tosi 2010, 730. This paper provides an overview of 16 theories that have been used in the literature to explain the phenomenon. The purpose of the incentives is to align the goals of executives and stakeholders.
Executive compensation as an agency problem lucian arye bebchuk and jesse m. Saks august 08, 2008 abstract we analyze the longrun trends in executive compensation using a new panel dataset of top executives in large publiclyheld firms from 1936 to 2005, collected from corporate reports. These include whether such compensation is excessive compared against provision of service and whether the compensation process is compromised by inadequately transparent negotiation perel 2003, p. Economic theories and compensation management 77 5. In other words, an employee is entitled to both the financial and the nonfinancial benefits in return for his contribution to the organization. Compensation is relevant to most other fields of human resource management such as recruitment and selection, training and development, performance appraisal, incentives, industrial and employee relations, promotion and separation and outside intervention in human resource matters. Different theories for managing compensation mba knowledge base. The subsistence theory ignores the importance of the role of the demand for labour and the role of trade unions in wage determination.
We start by presenting data on the level of ceo and other top executive pay over time and across firms, the changing composition of pay. The group dynamics theory of executive compensation. Corporate governance and executive compensation for corporate social responsibility abstract we link the corporate governance literature in financial economics to the agency cost perspective of corporate social responsibility csr to derive theoretical predictions about the relationship. We call these microfoundations behavioral agency theory. In addition to there being an intense debate among academics on its drivers, the ef. All economic theories of executive compensation accept this basic logic, and so stated, the logic is consistent with many sociological theories. Ecc provides consultation services for taxexempt organizations in regards to total allin compensation packages for most senior and responsible position holders to ensure that these arrangements are in full compliance with federal and state regulations. The unobservability of managerial effort is the main reason why executive compensation is largely based on firm equity rather than a flat salary. Ethics of executive compensation university of waterloo.
Behavioral theories are divided into three categories. This section of the site describes the typical executive compensation program and explains the most commonly used terms. Term paper on compensation theory and practice a study based on ucbl course code. How well does agency theory explain executive compensation. The theory does not consider wage differentials, which are bound to exist across regions. This paper describes new microfoundations for theorizing about executive compensation, drawing on the behavioral economics literature and based on a more realistic set of behavioral assumptions than those which have typically been made by agency theorists. Theory of motivation under theories of motivation, vrooms expectancy theory clearly defines strong relationship between moderation and compensation. Executive compensation or executive pay is composed of the financial compensation and other nonfinancial awards received by an executive from their firm for their service to the organization. Miller 1 introduction over the past three to four decades, income inequality in. Theories of wages wage structure wage fixation wage payment salary administration executive compensation incentive plans team compensation gain sharing incentive plan enterprise incentive plan profit sharing plan esops compensation management in multinational organisations.
The objective of a properly designed executive compensation package is to attract, retain, and motivate ceos and senior management. Indeed, the increase in academic papers on the subject of ceo compensation during the 1990s seems to have outpaced. Other similar schemes tie executive compensation and levels of benefits to shareholders returns and have part of executive compensation deferred to the future to reward longrun value maximisation of the corporation and deter shortrun. Indeed, the increase in academic papers on the subject of ceo compensation during. Executive compensation is a significant thing to consider when evaluating an investment opportunity.
Compensation policy are targeted at rewarding manpower for their skill, talent, performance, effort, responsibility and working conditions and increase their morale for efficient performance. As a consequence of the disconnect between executive compensation and the financial meltdown that battered the economy as a whole, the academic community is developing a new theory of executive compensation, which is referred to as the managerial power theory of executive compensation. Dorff associate dean for research and professor of law, southwestern law school. Corporate governance and executive compensation for corporate.
A survey of theory and evidence alex edmans, xavier gabaix, dirk jenter. The basic purpose of wage and salary administration is to establish and maintain an equitable wage and salary structure. Miller 1 introduction over the past three to four decades, income inequality in the united states has substan. Equity compensation is widely used for incentivizing skilled employees, particularly in new technology businesses. Corporate finance program, law and economics program, labor studies program. A survey of theory and evidence alex edmans lbs, cepr, and ecgi xavier gabaix harvard, nber, cepr, and ecgi dirk jenter lse and cepr june 26, 2017. The cost of the executive pay must be limited to the extent where the shareholders wealth does not get affected and, in fact, maximizes. Executive compensation has been a target for criticism by stakeholders and academics over the past several years. Norton 1994, 36, is related to a special ceo and executive compensation structure that rather focuses on a reward system than on absolute performance compensation. The relationship between executive compensation and firm. Despite the many fundamental differences between the theories, the assessments of the theories and the sketched current state of the literature as advanced here give rise to signs of convergence in theorizing about executive pay. Human resource management submitted to tanzila ahmed course instructor submitted by group name. Economic theories either assume that wages and prices are either fully fixed or fully flexible.
As well in practice as in theory debate still exists how executive pay levels and structures can be explained. Bebchuk and fried 2004 argue that executive compensation is set by ceos themselves rather than boards on behalf of shareholders, since many features of observed pay packages may appear inconsistent with standard optimal contracting theories. Compensation theory andpractice a studybasedonucbl 1. Since it is not feasible to assess every argument, we. Excerpts from existing literature majority of empirical studies concerning executive compensation, hinge on the agency theory. Executives who are improperly compensated may not have the incentive to. The group dynamics theory of executive compensation by michael b. Compensation and employee motivation what is human. Conyon and he, 2011, we focus on state influence and managers political connections and formulate a statestewardship theory. However, there are large disagreements over the question if rms do not pay their executives. A literature overview and critical assessment executive pay is a major issue in the corporate. Theories of compensation management human resource. This article studies traditional and modern theories of executive compensation, bringing them together under a simple u. It is typically a mixture of salary, bonuses, shares of or call options on the company stock, benefits, and perquisites, ideally configured to take into account government regulations, tax law, the.
The compensation is the remuneration given to the employees for the work they do for the organization. Fried e xecutive compensation has long attracted a great deal of attention from. Important theories that can explain executive compensation are as follows. The executive compensation is often designed with the intent to retain the executives during the bad times caused due to the adverse market and industry factors. Executive compensation, fat cats, and best athletes. Principalagent theory provides a way of characterizing optimal contracts in this situation, which has been applied extensively in this literature. This paper examines the extent to which agency theory may explain ceo compensation in stateowned enterprises soes in china during the 1980s. In this model, incentive alignment as a control mechanism is achieved by making some portion of agent compensation. The reputation of a ceo based on past performance directly correlates to compensation perel, 2003.
According to this theory, satisfying ones expectations and giving value rewarding for his efforts will result in motivation. Executive compensation is often cited as a realworld example of a principalagent problem, since the. Theories of compensation human resource management. As the authors state, their aim is to give a detailed account of compensation practice in the us with a view to revealing the. Yet hundreds of papers in economics, finance, accounting, and management have reached no consensus on whether executive compensation is efficient or whether empirically it conforms to the prediction of the principalagent theory. Context, the payperformance issue and future directions introduction the last thirty years has witnessed a striking volume and diversity of academic enquiry in the field of executive remuneration. Linking pay to performance critical issues to consider. Many of its propositions about executive compensation are made with a context of analysing the firms ability to generate profits and maximise productive output. Jul 05, 2010 different theories for managing compensation the basic purpose of wage and salary administration is to establish and maintain an equitable wage and salary structure. A new view from a longterm perspective, 19362005 carola frydman and raven e. Generally, the executive compensation packages are designed by the board of directors, particularly the compensation committee, which is comprised of the independent directors. Marginal productivity theory is mainly concerned with predicting the pay levels of executives. The principalagent model explains the reason for such compensation instead of a flat salary. The managerial power theory of executive compensation.
Ceo compensation, rationality, agency theory, bargaining, optimal contracting, utility maximization, neoclassical economics, ceo. How does executive pay compare across countries and how has it changed2. Incentives, agency theory, and executive compensation the. The standard economic approach for understanding executive pay. Politicians, regulators, investors, and executives themselves have all.
However, it may be that simple models do not capture several complexities of reallife settings. Compensation management is the art of using different pay and benefits to recruit and keep the best talent within an industry. Further, our discussion of cash compensation is mostly limited to pay mix issues, an area that has been of great interest to organizations as they move or consider a move to new programs such as stock plans for non executives, gainsharing, and profit sharing. In addition to there being an intense debate among academics on its drivers, the efficiency of current practices, and the case for reform, few topics have sparked as much interest among the general public. Where some of the theories are rooted in economic theory and consider executive pay mainly. Aug, 2009 the more general point is that you really cant say much sensible about a topic like executive compensation without understanding at least the basics of economic concepts such as agency theory. This theory is based on the assumption that, the rewardearning behavior is likely to be repeated, i. Similarly, in the case of expectancy theory, given by vroom, the employee is motivated to do a particular thing for which he is sure or is expected.
Published in volume 54, issue 4, pages 123287 of journal of economic literature, december 2016, abstract. The issue becomes whether or not the organisation structure helps the executive to formulate and implement plans for high corporate performance donaldson 1985. The general objective of this study is to measure the relationship between executive compensation and firm performance among the commercial banks listed at the nairobi stock exchange. Ahadujjaman 10010101 faglul karim raihan 1001010142 abdul aziz 1001010127. This article studies traditional and modern theories of executive compensation, bringing them together under a. Sep 03, 2012 compensation theory andpractice a studybasedonucbl 1. Pdf compensation is a systematic approach to providing monetary value to employees in exchange for work performed.
It includes several charts, including one below that shows the share of compensation that is at risk by executives, as compared with managers and hourly employees. As well in practice as in theory debate still exists how executive pay levels and structures. In the remainder of this chapter, we provide a survey of theories. Tournament theory and its relevance to executive pay. Its secondary objective is the establishment and maintenance of an equitable labourcost structure i.
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