(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 673

648 PART 4 • Information, Market Failure, and the Role of Government
For years, many economists believed that
executive compensation reflected an appropriate
reward for talent. Recent evidence, however, suggests that managers have been able to increase
their power over boards of directors and have
used that power to extract compensation packages that are far out of line with their performance
and contributions to the growth of their firms. In
essence, managers have steadily increased their
ability to extract economic rents. How has this
happened?
First, most boards of directors do not have the
necessary information or independence to negotiate effectively with managers. Directors often
cannot monitor executives’ activities and therefore
cannot negotiate compensation packages that are
tightly linked to their performance. Furthermore,
boards consist of a mix of inside members, who
either are or represent top executives, and outside
members, who are chosen by and are often on
close terms with top executives.13 Therefore, directors have a strong incentive to support executives

in order to be re-nominated to the board or otherwise rewarded.
Research has shown that high levels of CEO pay
are negatively correlated with a firm’s accounting
value and profitability.14 In other words, the higher
the CEO’s pay, the lower the firm’s profitability is
likely to be. In addition, CEOs with unusually high
pay were more likely to stay at a company despite
poor economic results. These effects are intensified
at companies where the board is entrenched and
shareholder rights are limited.
“Golden parachutes,” generous severance packages that CEOs can negotiate with their boards,

have also come under fire recently. Some argue that
such guarantees free CEOs from board and shareholder pressure to focus on short-term growth and
enable them to focus instead on their firms’ longterm growth. However, it has been shown that CEOs
with golden parachutes are less likely to worry about
long-term growth, and—when negotiating the sale
of their firm to another company—are more likely to
agree to acquisition terms that hurt shareholders.15

Reward structures that focus on profitability over a 5- to 10-year period are more
likely to generate efficient incentives than more shortsighted reward structures.
We will consider some additional solutions to this important principal–agent
problem in the next section.

The Principal–Agent Problem in Public Enterprises
The principal–agent framework can also help us understand the behavior of
the managers of public organizations. These managers may also be interested
in power and perks, both of which can be obtained by expanding their organization beyond its “efficient” level. Because it is also costly to monitor the
behavior of public managers, there are no guarantees that they will produce
the efficient output. Legislative checks on a government agency are not likely
to be effective as long as the agency has better information about its costs than
the legislature has.
Although the public sector lacks some of the market forces that keep private managers in line, government agencies can still be effectively monitored.
13

Killinger was the chairman of Washington Mutual’s board until he was forced out two months
before the bank failed.

14

In 2007, Killinger, who was also chairman of Washington Mutual’s board of directors, was paid

$18.1 million, making him the highest paid CEO of any publicly traded company (http://www.
equilar.com/NewsArticles/062407_pay.pdf). This was especially true when the CEO took home the
largest portion of the pay going to the firm’s top-five executives. For more detailed discussion and
analysis, see Lucian A. Bebchuk, Martjin Cremers, and Urs Peyer, “The CEO Pay Slice,” Journal of
Financial Economics (Spring 2012).
15

Lucian A. Bebchuk, Alma Cohen, and Charles C. Y. Wang, "Golden Parachutes and the Wealth of
Shareholders,” Harvard Law School Olin Discussion Paper No. 683, December 2010.