Tackling the Managerial Power Problem: The Key to Improving Executive Compensation

Executive pay continues to attract much attention from investors, financial economists, regulators, the media, and the public at large. The dominant paradigm for economists' study of executive compensation has long been that pay arrangements are the product of arm's-length bargaining—bargaining between executives attempting to get the best possible deal for themselves and boards seeking only to serve shareholder interests. But the actual pay-setting process has deviated far from this arm's-length model. Managerial power and influence have played a key role in shaping the amount and structure of executive compensation. Directors have had various economic incentives to support, or at least go along with, arrangements favorable to the company's top executives. The inability or unwillingness of directors to bargain at arm's length has enabled executives to obtain pay that is higher and more decoupled from performance than would be expected under arm's-length bargaining.