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Chapter 10: Problem 4

Executive compensation, based on performance, can theoretically constrain pay, but companies are paying their top executives more and more. The median compensation of a CEO in 2013 was \(\$ 13.9\) million, up 9 percent from 2012 Source: CNBC, April 28, 2014 What is the economic problem that CEO compensation schemes are designed to solve? Would paying executives with stock align their interests with shareholders?

Short Answer

Expert verified
CEO compensation schemes address the principal-agent problem. Paying executives with stock can align their interests with shareholders by incentivizing them to increase stock value.

Step by step solution

01

Understanding the Economic Problem

CEO compensation schemes are designed to address the principal-agent problem. This issue arises because the goals of the company owners (shareholders) and the managers (CEOs) may not align. Shareholders want to maximize their returns, while CEOs might pursue personal goals such as job security and perks.
02

Linking Compensation to Performance

To align the interests of CEOs with those of the shareholders, companies use performance-based compensation schemes. These can include bonuses, profit sharing, and stock options. The theory is that if a CEO's compensation is tied to the company's performance, the CEO will work harder to improve it.
03

Impact of Stock-Based Compensation

Paying executives with stock or stock options can align their interests with those of the shareholders. When CEOs own company stock, they directly benefit from an increase in the company's stock price, which incentivizes them to work in the shareholders' best interest to increase the stock value.
04

Challenges and Real-World Implementation

While stock-based compensation can help align interests, it also has challenges. CEOs might engage in short-term tactics to boost stock prices temporarily without considering long-term health. Therefore, a well-balanced compensation structure is critical.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

principal-agent problem
The principal-agent problem is a key concept in understanding CEO compensation schemes. It arises when there is a disconnect between the goals of the principals (shareholders) and the agents (CEOs). Shareholders are primarily interested in maximizing their returns on investment. They want the company to perform well and the stock value to increase. On the other hand, CEOs might have different motivations. They could be focused on job security, personal perks, or career advancement. This misalignment can lead to decisions that benefit the CEO personally but do not necessarily optimize shareholder value. For example, a CEO might pursue aggressive expansion strategies to enhance their resume, even if such steps are risky for the company. Aligning the interests of CEOs with those of shareholders through compensation schemes attempts to solve this economic problem.
performance-based compensation
Performance-based compensation is designed to ensure that CEOs work towards the same goals as shareholders. Instead of receiving a fixed salary, CEOs get paid more if they meet certain performance criteria. This can include metrics like revenue growth, profit margins, or stock price increases. The main idea is that by linking compensation to performance, CEOs will be motivated to improve the company’s performance. Methods for performance-based compensation include:
  • Bonuses: Extra payments based on achieving specific targets.
  • Profit Sharing: A share of the company's profits distributed to executives.
  • Stock Options: Rights to buy company stock at a predetermined price.
These incentives encourage CEOs to make decisions that will benefit shareholders. However, ensuring these targets align with long-term growth rather than short-term gains remains a challenge.
stock options
Stock options are a popular method of performance-based compensation. They give executives the right to purchase company stock at a predetermined price, known as the exercise price, sometime in the future. If the company performs well and the stock price increases above the exercise price, the CEO can buy the stock at the lower price and sell it for a profit. This potential for financial gain can closely align the CEO’s incentives with shareholders. If the company prospers, both the CEO and shareholders benefit. However, stock options also come with challenges:
  • Short-Term Focus: CEOs might engage in practices that boost the stock price temporarily.
  • Risk of Manipulation: CEOs might time the disclosure of information to influence stock prices.
  • Market Risk: External factors can affect stock prices, unrelated to a CEO's performance.
To mitigate these issues, companies often impose vesting periods, requiring CEOs to stay with the company and hold the stock options for several years before exercising them. This encourages a long-term commitment to the company's success.

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Most popular questions from this chapter

One year ago, Jack and Jill set up a vinegarbottling firm (called JJVB). Use the following data to calculate JJVB's opportunity cost of production during its first year of operation: Jack and Jill put \(\$ 50,000\) of their own money into the firm and bought cquipment for \(\$ 30,000\) They hired one worker at \(\$ 20,000\) a year. Jack quir his old job, which paid \(\$ 30,000\) a year, and worked full-time for JJVB. : Jill kept her old job, which paid \(\$ 30\) an hour, but gave up 500 hours of leisure a year to work for JJVB. I JVB bought \(\$ 10,000\) of goods and services. The market value of the cquipment at the end of the year was \(\$ 28,000\) ack and Jill have a \(\$ 100,000\) home loan on which they pay interest of 6 percent a year.

Use the following data to work. Four methods of completing a tax return and the time taken by each method are with a \(\mathrm{PC}, 1\) hour; with a pocket calculator, 12 hours; with a pocket calculator and paper and pencil, 12 hours; and with a pencil and paper, 16 hours. The \(\mathrm{PC}\) and its software \(\cos t \$ 1,000,\) the pocket calculator costs \(\$ 10,\) and the pencil and paper cost \(\$ 1\). Which method is economically efficient if the wage rate is (i) \(\$ 5\) an hour, (ii) \(\$ 50\) an hour, and (iii) \(\$ 500\) an hour?

School districts in many states experiment with plans that compensate teachers partly based on classroom performance, rather than their years on the job and coursework completed. Working with mentors to improve their instruction and getting bonuses for raising student achievement encourages efforts to raise teaching quality. How does "merit pay" attempt to cope with the principal-agent problem in public education?

Two leading design firms, Astro Studios of San Francisco and Hers Experimental Design Laboratory, Inc. of Osaka, Japan, worked with Microsoft to design the Xbox 360 video game console. IBM, ATI, and SiS designed the Xbox 360 's hardware. Three firms Flextronics, Wistron, and Celestica- manufactured the Xbox 360 at their plants in China and Taiwan. a. Why do you think Microsoft works with a large number of other firms, rather than performing all the required tasks itself? b. What are the roles of transactions costs, economics of scale, economies of scope, and economies of team production in the design, manufacture, and marketing of the Xbox?

Starbucks has more than 10,000 employees, 6,700 stores, which serve some 50 million customers in 51 countries each week. Geoffrey mwa Ngulumbi runs the family-owned fair trade farm in Tanzania and supplies Starbucks with coffee beans and other raw materials. a. How does Starbucks coordinate its activities? Is it likely to use mainly a command system or an incentive system? Explain. b. How do you think Geoffrey mwa Ngulumbi coordinates the activities of his farm? Is he likely to use mainly a command system or also to use incentive systems? Explain. c. Describe, compare, and contrast the principalagent problems faced by Starbucks and Geoffrey mwa Ngulumbis farm. How might these firms cope with their principal-agent problems?
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