18.5Executive Compensation

Economists describe the relationship between owners and management as a principal-

agent relationship, with stockholders considered the principalsand management as

the agentshired by the principals to take actions on their behalf. To solve the agency

problemthat arises from the conflicting interests of agents and principals, economists

Grinblatt1300Titman: Financial	V. Incentives, Information,	18. How Managerial	© The McGraw1300Hill
Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

644Part VIncentives, Information, and Corporate Control

have considered various ways to compensate agents in order to motivate them to work

for the benefit of the principals.

The Agency Problem

Perhaps the earliest discussions of agency problems involved the relationship between

a tenant farmer (the agent), whose effort cannot be directly observed, and the owner of

the farm (the principal). To motivate the tenant farmer to work hard, the amount of

compensation must be tied to the farm’s output. However, because the crop yield is

determined by unobservable soil conditions and unexpected weather, as well as by the

farmer’s effort, tying the farmer’s compensation too strongly to the farm’s output may

not be optimal. Doing so would expose the farmer to uncontrollable risks which can

be borne more efficiently by the owner of the farm because he may be able to diver-

sify away much of this risk. As a result, there is a trade-off between the incentive ben-

efits of tying compensation to output and the disadvantages of subjecting the tenant

farmer to excessive risk over which the tenant has no control.

Two Components of an Agency Problem.The tenant farmer discussion above illus-

trates the two essential features of an agency problem: uncertainty that the agent can-

not control and a lack of information on the part of the principal. If the principal were

able to observe the actions of the agent and if there were no free-rider problem, there

would be no incentive problems. The principal could simply force the agent to work

in his or her interests. The agent who refused could be fired. In addition, if the agent

were not averse to bearing the risk of a particular project or, alternatively, if there were

no risk that the agent could not control, the principal could motivate the agent to make

value-maximizing choices by having the agent bear all of the risks associated with his

or her actions. In short, if a manager were not averse to risk and had the capital, the

best situation would be one in which the manager owned all of the firm’s stock.

Measuring Inputs versus Measuring Outputs.The agency problem can be sub-

stantially alleviated if the principal can accurately observe the agent’s actions. The prin-

cipal can do this in one of two ways: (1) Closely monitor the agent to ensure that he

or she works the specified number of hours at the required level of intensity—that is,

to measure the agent’s labor input;or (2) indirectly measure the agent’s actions by

observing the agent’s output.

Before the mid-1970s, most large U.S. corporations tried to solve the agency prob-

lem by measuring inputs. Systems were put in place to monitor managers to make sure

that they were doing their jobs appropriately. However, although it may be possible to

evaluate the quantity of a manager’s effort, it is difficult to evaluate the quality of that

effort—in other words, the extent to which the manager’s effort creates value for the

firm. Moreover, even if the quantity and the quality of a manager’s effort could be eval-

uated, it would be extremely difficult to contractually specify a bonus that is tied to

such a vague concept. As a result, since the mid-1970s, there has been a worldwide

trend toward evaluating and compensating managers based on outputs (for example,

profits) rather than inputs. In other words, there is an increased tendency of firms to

tie employees’pay to performance.

Designing Optimal Incentive Contracts.Afirm’s profits are determined by a num-

ber of factors. Some of these factors are under the manager’s control, but others are

not. In general, well-designed compensation contracts minimize the extent to which

Grinblatt1302Titman: Financial	V. Incentives, Information,	18. How Managerial	© The McGraw1302Hill
Markets and Corporate	and Corporate Control	Incentives Affect Financial	Companies, 2002
Strategy, Second Edition		Decisions

Chapter 18

How Managerial Incentives Affect Financial Decisions

645

managers can be penalized by factors outside of their control. For example, the tenant

farmer should be penalized less for exhibiting low output in years of little rainfall than

for poor performance in years of abundant rainfall. Hence, information about rainfall

can be used to reduce the agent’s risk and improve the relationship between the tenant

farmer and the landowner.

In applying this logic to management compensation contracts, one would conclude

that a manager’s compensation should not be tied simply to the firm’s stock price or earn-

ings performance but to the amount that the firm’s stock return or earnings exceed the

return on the market in general or to the performance of other firms in the industry.¹⁶

Minimizing Agency Costs.Agency costsrepresent the difference between the value

of an actual firm and the value of a hypothetical firm which would exist in a more per-

fect world where management and shareholder incentives are perfectly aligned. The dis-

cussion in this subsection provides ways that firms can minimize agency costs. These

are summarized in Result 18.9:

Result 18.9

Agency problems partly arise because of imperfect information and risk aversion. Agencycosts thus can be reduced by improving the flow of information and by reducing risk. Tominimize the risk borne by managers, optimal compensation contracts should eliminate asmuch extraneous risk (or risk unrelated to the manager’s efforts) as possible.