Relationship Between Executive Remuneration And Firm Performance example essay topic

Abstract The real wage of the average worker in the United States has fallen 13 percent in the last 20 years, while the average chief executive officer (CEO) has received a pay raise of over 300 percent (Crystal, 1991). This glaring contrast has sparked an explosion in academic research on executive compensation. The argument that Crystal (1991) proposed, ! ^0 just about all of the rational factors you can think of, taken together, don! t play a big role in determining executive pay! +/-, is dominant in this medium. Despite this fact, research on executive paychecks has continued to grow as the literature is truly interdisciplinary across the fields of economics, finance and accounting, industrial relations, organizational behavior and strategy (Murphy 1999). Labour economists have drawn upon many conclusions on executive remuneration from a large theoretical and empirical interdisciplinary literature.

They argued that executive remuneration offers opportunities to analyze many concepts of the economics of managerial labor market. Hence, in this essay I am going to explore these opportunities by looking at the functioning market in the captioned perspective. The managerial labor market, which contains a range of firms that are with managerial jog openings and a range of potential managers who have different human capital characteristics, has two sides. On the one hand, the demand side, which is made up of employees who produce goods and services, and employers who purchase executive effort, concerns paid managerial labor as a function of the latter!'s pay and productivity. On the other hand, the supply side composes executives who are assumed to switch firms according to the characteristics of the firm and the salary. By understanding the two sides and the disciplining effect of the managerial labor markets, firms can identify the market forces that determine the optimal executive remuneration contracts so as to maximize firm value (Fama 1980, Fama & Jensen 1983).

The use of such knowledge align with the understanding of managerial behavior with owners! interests can help firms to choose corporate policies that best signal their own value to the labor market such as CEO remuneration. Since one of the most important objectives of firms is to maximize their value, executives are disciplined into undertaking strategies preferred by the stockholders that maximize the firm!'s stock price (Fama 1980). Hence, suggesting the major functioning of managerial labor market are to determine the rational level and structure of remuneration package and to reflect the managerial labor market!'s control of executives! behavior to maximize firm value. Despite the fact that executive remuneration schemes across firms and industries are substantially heterogeneous and complex, it can boiled down to four basic elements: a base salary, bonus, stock options and long term incentive plans.

I will examine these in turns. First, base salary for executives is a key component of the pay package. It represents the! ^0 fixed component! +/- in executive contracts. Second, bonus is paid annually based on accounting profit, budget, prior-year performance or incentive zone. Third, stock options are agreements that the executive may purchase from the firm at any time within a stated period or a given number of shares of its stock at a price specified on the date of granting (Easton & Rosen 1983).

This, with regards to political, economic, mechanical and behavioral factors, has made it the most pronounced method in executive remuneration in the last two decade (Murphy 1999). This is because it relates the executive!'s income most directly to the concern of shareholders, i.e. the value of the firm. Finally, the long- term incentive plan, which is based on rolling "C average 3-or-5-year cumulative performance. As I have stated before, the major function of the managerial labor market is to set a rational level and structure of the executive remuneration package so to maximize the firm!'s value, i.e. the executive remuneration reflects the managerial labor market!'s control of executives! behavior to maximize firm value.

Hence, making the relationship between executive remuneration and company!'s performance the fundamental concern. In order to understand this concern, we have to examine the agency theory as it is the principal theory guiding research on the pay-performance relationship (Bernstein 1997; Crystal, 1995; Lowenstein 1996; Gomez-Mejia 1994; Gomez-Mejia and Wiseman 1997; Fama & Jensen 1983; Jensen & Mecking 1976). Agency theory states that many social relationships can be best understood as interactions between two parties: principal and an agent. The agent performs certain actions on behalf of the principal, who must delegate some authority to the agent (Jesen and Mecking, 1976). By examining the theory, firms can be in a better position when dealing with contract problems that are governed by an exchange between individuals who have divergent interests. Typical organization in most western countries, which has a corporate structure with thousands or millions of owners, each having a small claim on the firm, can be used to make a clear illustration of the above.

Shareholders of the organization are widely dispersed, delegating responsibility to running the business to hired executives. Given their limited control over corporate affairs and executive!'s limited stake in the firm!'s equity and risk, executive is expected to engage in behavior that promotes their personal wealth, perquisite consumption, job security and prestige but is detrimental to stockholders! interest in maximizing the value of the firm (Jesen & Mecking 1976). The literature on agency theory has suggested that the optimal solution to goal incongruent is to have remuneration contracts that link executive remuneration to the performance of the firm. Hence, through the executive!'s holdings of stock, restricted stock, and stock options, an executive remuneration is explicitly tied to the principle!'s objective, i.e. the executive wealth is implicitly tied to the stock-price performance through accounting-based bonus and option (Murphy, 1999). This in turns suggests that the performance-based remuneration will induce self-interested, utility-maximizing, risk-and-effort-averse agents to act on the behalf of principals who want to increase the value and performance of their firms (Eisenhardt 1989; Jesen & Mecking 1976). This view, however, has failed to find supportive evidence of such positive relationship (Jesen & Murphy 1990; Kerr & Bettis 1987; Mceachern 1975; Rich & Larson 1984).

These researchers have claimed that the relationship between executive remuneration and firm performance is either nonexistent or is of a very weak nature, that is, remuneration is significantly unrelated to the firm!'s performance (Crystal 1991) or if related, then only related to the short-term performance (Rapport 1978). In contrast, some studies claim that the executive remuneration is more closely related to the firm!'s size than to the firm!'s profits (McGuire 1962). Therefore this inconclusive effect of executive remuneration on the functioning of managerial labor market has brought a great puzzle to the researchers. Therefore, to understand the functioning of managerial labour market, alternate mechanisms and criteria outside the agency framework are examined.

These mechanisms include marginal productivity theory, internal and external market theory, board control theory, information-processing theory and social comparison theory, will be examined in turns. Marginal productivity theory views the managerial labor market as perfectly competitive, that is there are a large number of individual, perfectly informed buyers and sellers of homogeneous executives. Hence, remuneration, viewed as the price of labor, is seen as being determined by the intersection of labor demand and supply curves in the market. Firm maximizes its profits in the short run by employing executives up to the point where the executive remuneration equals executive!'s marginal revenue product (MRP). It equals to executive!'s marginal physical product (MPP) multiplied by marginal revenue (MR). According to economists, executives are assumed to be highly mobile and fully informed and would supply their labor service to the highest bidder.

Executive supply and demand are quickly brought into a state of equilibrium through executives moving from one firm to another in response to opportunities to obtain higher earnings. Thus, by looking at the profit-maximizing firm!'s short-run demand curve for executives, which is the schedule of its marginal revenue product, executive remuneration can be determined by the value of his contribution to the firm. Another influential theory regarding the internal and external managerial labor market of executive pay is made by Fama (1980). He argued that the external labor market exerts many direct pressures on the firm to sort and compensate executives according to performance.

Hence, there is a natural process of monitoring from higher to lower levels of management, i.e. each executive is concerned with the performance of executive above and below him since his marginal product is likely to be positive of their. This leads to a careful consideration of the mechanics, which the potential executives used to seek information about the responsiveness of the system in rewarding performance. Thus this market mechanism ensures the rights of shareholders and the rights of the top management are respected. The third theory views the board as the legal representative and formal guardian of stockholders! interests, i.e. the board members have the task to oversee and ratify managements! decisions and to evaluate reward and sanction executives! performance (Bacon & Brown, 1975). Research has focused on two broad factors, executive duality and the proportion of outsiders on a board in evaluating the influence the board exerts in setting executive pay. Finkelstein and Hamrick (1989) found no evidence of a relationship between executive remuneration the percentage shareholdings of outside directors.

Furthermore, Boyd (1994) found that! ^0 contrary to expectations, the ratio of insiders was negatively associated with compensation! +/-. Other work has also shown that the proportion of outside directors appointed to a board by its executive has a positive effect on executive remuneration (Main, 1994).

This theory also suggests that there is a threat of board actions and termination in response to observed managerial inefficiency or opportunism, which is likely to impel executives to refrain from behavior that is in conflict with stockholders! interests. Thus the characteristics of the board such as its structure and its effectiveness are key determinants on the executive remuneration and the sensitivity of the relationship between remuneration and performance. Information-processing theory is very important when contributing on the recent work on executive remuneration as it focuses on the substantive nature of the job performed by executives on the social and political context of their pay. There are several reasons for expecting the remuneration of executive is in accordance to the information processing demands they face instead of the firm!'s performance. First, information-processing tasks are a major part of executive!'s jobs and the execution of such tasks is critical to organizational functioning and performance (Eisenhardt 1989; Galbraith 1973; Halrblian & Finkelstein 1993; Minzberg 1973; Thompson 1967). Second, executives! jobs vary considerably in the information-processing demands they create.

The common theme of such research is around those demands that are significantly affected by three firm-level factors: (1) the number and interdependence of a firm!'s business activities. (2) the technologies the firm employs and (3) the management used to administrate the firm (Chandler 1962; Date & L engel 1986; Galbraith 1973; Grekov 1989; Hill & Huskisson 1987; Jones & Hill 1988). This theory, therefore, shows that executives who face particularly high information-processing demands due to the diversification approach to technology their firms adapted will be expected to be paid more, as their ability to cope with these demands allow them to make larger marginal contributions to firm performance (Henderson & Fredrickson 1996). In an informational efficient executive labor market, it is unrealistic to expect changes in executive pay to be closely related to firm performance measure, i.e. it has a low sensitivity of pay-for-performance. Finally, the use of social comparison theory provides us an understanding of socio-psychological explanation of remuneration.

This theory is based on the remise that individuals have the need to evaluate their opinions and abilities. They compare with others who have similar abilities and opinions. In the case of managerial labor market, the implication is that the remuneration committee will set the pay of executives who are perceived to be slightly better by striking a balance between providing financial incentives to executives to improve firm performance and avoiding a binding! ^0 participation constraint! +/- (Smith & Stnabsju 1995). That is to ensure that executives remain loyal to firms by offering levels of pay comparable to the external labor market alternatives.

So far, I have discussed what factors determine the executive remuneration and how they effect on the firm!'s performance from the economics, psychological and sociological perspectives. However, these are not sufficient enough to understand the functioning of the managerial labour market fully. Recent work, perhaps responding to the difficulties with traditional economies-based research on remuneration, has begun to move beyond established frameworks and suggests some new factors that may influence the remuneration-setting process. Managerial discretion, efficient wages model, tournament models (Lazer & Rosen 1981; Rosen 1986), resource dependence theory etc are some examples of paradigms that explain executive pay, which have moved the stream of research on executive remuneration forward greatly. To sum up, research on executive compensation has a long history. Much of this work has adopted the economics perspective, which views social, political or strategic factors as the determinants of executive pay.

In this essay, I have tried to explore the functioning of managerial labor market based on the existing comprehensive theoretical and empirical literature on executive remuneration. My conclusion is that although the pay for performance is consistent with agency theory, the relationship between executive remuneration and performance is more complex than the empirical research has presumed. Since the extent to which the functioning of managerial labor market is effected by the executive remuneration is still inconclusive, a broader perspective should be adopted by firms in order to have a better understanding of the functioning of managerial labor market from the executive remuneration stand..