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40. Dwell on Sources of Managerial Power.

Bebchuk and Fried present an alternative approach to optimal contracting, based on the idea of managerial power inside the firm. The idea is that the CEO has a good deal of control over the board, and this control includes the power to set a large part of his own compensation. Of course, there must be some factors that limit executive compensation; in addition to market forces, Bebchuk and Fried introduce an additional type of cost that they refer to as “Outrage Costs.” Outrage costs occur when there are costs to the executives and directors from a public reaction to executive compensation that is perceived as excessively high. The difference between the managerial-power and principal-agent explanations is stark: The level of pay in the principal-agent approach is set so that the CEO receives at least his reservation utility, so that he is paid just enough to keep him from leaving and going to another firm. In contrast, the level of pay in the managerial power approach is set as high as possible, with the upper bound on pay determined by public perceptions

Managerial power theory argues that executive compensation is often excessive when compared against a hypothetical, economically efficient compensation contract. The theory also argues that executive pay does not correlate to performance. In other words, high earners are not necessarily high performers.

5 Sources of Power in managerial:

Legitimate Power

Legitimate power is also known as positional power. It's derived from the position a person holds in an organization's hierarchy. Job descriptions, for example, require junior workers to report to managers and give managers the power to assign duties to their juniors. For positional power to be exercised effectively, the person wielding it must be deemed to have earned it legitimately. An example of legitimate power is that held by a company's CEO.

Expert power

Knowledge is power. Expert power is derived from possessing knowledge or expertise in a particular area. Such people are highly valued by organizations for their problem solving skills. People who have expert power perform critical tasks and are therefore deemed indispensable. The opinions, ideas and decisions of people with expert power are held in high regard by other employees and hence greatly influence their actions. Possession of expert power is normally a stepping stone to other sources of power such as legitimate power. For example, a person who holds expert power can be promoted to senior management, thereby giving him legitimate power.

Referent Power

Referent power is derived from the interpersonal relationships that a person cultivates with other people in the organization. People possess reference power when others respect and like them. Referent power arises from charisma, as the charismatic person influences others via the admiration, respect and trust others have for her. Referent power is also derived from personal connections that a person has with key people in the organization's hierarchy, such as the CEO. It's the perception of the personal relationships that she has that generates her power over others.

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