How CEOs should be paid
Exercise
Using as a basis the standard principal-agent model, design and discuss an incentive system for the Chief Executive officer or CEO, i.e., the boss, of a firm such as General Motors or BBVA. Please, make explicit your assumptions about the preferences of the shareholders and the CEO. You might want to provide a brief discussion of:
(1) the features of the situation or problem;
(2) the basic solution;
(3) the problems with such a solution; and
(4) some potential solutions to such problems.
Note: If you need to review the principal-agent model, you may use as a source Tirole (1988, the first part of section 2.1 on pp. 35-38) or Macho and Pérez (1994, Ch. 3).
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TIROLE, J., 1988, The Theory of Industrial Organization, MIT Press, Cambridge, MA. Traducido al castellano con el título La teoría de la organización industrial, Ariel, Barcelona, 1989.
MACHO STADLER, I., y D. PEREZ CASTRILLO, 1994, Introducción a la economía de la información, Ariel, Barcelona.
Analysis
Some general issues are the following:
(1) It is a moral hazard situation or problem, with asymmetric information. Performance is affected by the CEO effort and exogenous variables.
(2) The basic solution is to pay the CEO with shares.
(3) However, if the CEO is risk-averse, inefficient risk allocation (aggravated if the CEO has firm-specific investments in terms of human capital) motivates the CEO to adopt inefficient financial investment and hedging policies to reduce his risk. A solution to this problems is provided by using share options, which yield asymmetric compensation, thus guaranteeing the CEO a floor.
(4) However, they may induce him to adopt extremely risky strategies even if they reduce value. Furthermore, when granted they are usually “in the money” (i. e., they would already yield a profit if they were exercised at that moment). As a consequence, managers tend to behave conservatively. For information on the current discussion of these a related issues see the articles “Cream” and “The Need for Greed” in The Economist (May 4th., 1996, pp. 12 and 80). (Have not you subscribed yet?).
Two possibilities worth thinking about are:
(a) Using lower-intensity incentives (“low-powered incentives” in Williamson’s jargon), like profit sharing, which might have many drawbacks, but solve some of the previous problems.
(b) Letting the CEO do insider trading on the company shares, as argued by Henry Manne et al. since Manne’s 1966 book. The latter possibility would be illegal nowadays in most civilized countries and some European ones.
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