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Executive compensation practices hijacked, distorted by narrow economic theories

By Eric W. Orts


“Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist.”

Keynes’ warning applies to debates about skyrocketing levels of executive compensation in the United States and elsewhere. Even leading advocates of reform who insist on better measures of “pay-for-performance” continue to be misled by narrow economic theories that lie at the root of the problem.

Two main economic theories have been translated into the executive compensation debate and established dominance in the last few decades. One is the “agency costs” approach to corporate governance which focuses on the relationship between “principals” and “agents.” This approach is also known as principal-agent theory. Another theory posits an “efficient capital market hypothesis,” which argues that stock prices are the most accurate possible estimation of a public corporation’s value. The combination of these two theories has led in practice to extreme and sometimes absurdly high levels of executive pay. We need to rethink the applicability of these theories. Entrenched interests in both business and academia will resist. Without a change in theory, however, no serious change can be anticipated in practice.

Principal-agent theory derives from a basic insight. Most business relationships involve legal relationships in which one person (the “agent”) agrees to work on behalf of another (the “principal”). The most common example is employment. Principal-agent theory assumes that self-interested motivations will cause agents to tend to “shirk” their responsibilities. To solve this problem, the principal must either oversee the agent (“monitoring”) or find creative ways to tie the agent’s economic interests to the principal’s (“bonding”). In law, however, there is a contrary assumption: the agent owes a “fiduciary duty” to the principal. Acting selfishly and against the principal, such as by taking “secret profits,” is viewed as wrong and punished.

Principal-agency theory is useful. People often behave according to self-interest, and it makes sense to examine firms in terms of agency costs to improve organizational efficiency. The error comes when this economic theory is taken as a complete explanation of the complex structures and motivations in large corporations. Principal-agent theory attempts cut through this complexity by arguing that only two major groups in a corporation matter. The shareholders are called “principals,” and the executives are called the “agents.” The economist then “solves” for the problem agency costs.Executives who otherwise would act only in their own self-interests are difficult to monitor effectively (because shareholders are often dispersed in corporations). Bonding is therefore advocated as the best solution. In practice, this translates into paying executives in stock or stock options. An executive performs in the best interests of shareholders, according to this theory, because it is in his or her own self-interest to do so.

This economic theory does not bear close comparison with the reality of large business corporations. The law gives a different story. Under a traditional legal account, executives owe “fiduciary duties” to act in the best interests of the shareholders and the corporate business as whole. This idea of the corporate interest being larger than shareholders makes sense. Long-term success depends on many factors, including the effective management of employees, creditors, suppliers, and customers. Great CEOs lead their companies by example and by managing legal and other risks effectively. They make the right calls when faced with ethical dilemmas which, at a minimum, keep their firms out of serious legal trouble. The principal-agent theory of the firm oversimplifies the tasks of executive leadership. It also assumes that CEOs will be motivated only by selfishness, when instead a great CEO must exhibit leadership abilities that instill trust and motivate others. Adhering strictly to a principal-agent view of the firm destroys expectations of trust and integrity in corporate leaders.

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The second problematic economic theory is the efficient capital market hypothesis. This theory posits that current stock market trading prices are the best estimation of corporate value. This may often prove to be the case, but not always. The rising field of behavioral finance shows that investors are also subject to social psychological influences, causing “panics” (crashes) or “irrational exuberance” (booms). If so, then stock prices are not always a good measure of the current value of a company. Paying an executive for stock-price performance can therefore often get it wrong.  During booms, executives may be radically overpaid. During busts, they may be unfairly penalized.

Recalling the legal structure of firms provides a better explanation. Business corporations are organizations of power and authority, not simply a “nexus of contracts” or loose assembly of individuals. Executives exert substantial control over the organizations that they ostensibly also serve. They therefore have great responsibility, and the legal and ethical norms governing expectations for their behavior are essential. A narrow view of executives as essentially selfish leads to a self-fulfilling prophecy (so to speak). Executives will then use their power and authority to overpay themselves. Shareholders may not object and may even cheer them on in the short-run because gains in executive stock options mean gains in shareholder value. But these economic theories do not work well for the long-run. Executive selfishness eventually destroys firms and harms the many people who compose firms and rely on them.

Another unanticipated consequence of following these economic theories has been that they have created high-powered organizational incentives for executive fraud. In theory, executives should work to increase stock price honestly. In practice, many executives have been tempted to “cook the books,” “manage earnings,” and engage in other deceptive activities to hit short-term stock option targets. As a result, we have witnessed an unending wave of high-level corporate fraud and misbehavior.

It will not be easy, but it is time to constrain the influence of narrow economic theories of the firm and to recover some traditional legal values. We should eschew economic theories that assume that business executives are motivated only by greed and self-interest. Instead, we need to return to old-school values of fiduciary duty, integrity, and a larger vision to manage companies in the interests of others who depend on them and who contribute to their success. Healthy compensation for executives should follow only when these larger goals are met.

Eric W. Orts is the author of Business Persons: A Legal Theory of the Firm, which presents a foundational legal theory of the firm in contradistinction to prevailing economic theories and discusses policies informing executive compensation as an example of how economic theories have gone wrong. Eric Orts is the Guardsmark Professor of Legal Studies and Business Ethics at the Wharton School of the University of Pennsylvania. He is also a Professor of Management, faculty director of the Initiative for Global Environmental Leadership, and faculty co-director the FINRA Institute at Wharton. Currently, he is a visiting professor at INSEAD in France.

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Image credit: Time to pay. © Gustavo Andrade via iStockphoto.

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