Compensation and management incentives
The compensation of managers can be structured to bring the interests of managers more into harmony with those of shareholders. Corporations usually tie the compensation of managers to the market success of the business. The salary increases and bonuses of most high-level managers are directly related to the firm’s profitability and the price of its shares. How important are these incentives? In recent years, salaries have constituted only about 10 percent of the compensation of chief executive officers (CEOs). The other 90 percent has been in the form of bonuses, often stock awards and stock options (the right to buy shares at a certain price). Both forms of payment have a “vesting period,” which means they will be granted only if the CEO stays with the firm for a certain amount of time and meets specific goals. Policies like these encourage corporate managers to maximize the the firm’s profits – and, not coincidentally, the value – of its shares both strongly in the interest of shareholders. Managers who develop a good track record of adding value to the firm gain not only more pay and greater job security, but also better job offers should they later decide to switch firms.
Incentive pay brings with it another unwanted incentive for managers, though: the incentive to gain personally by manipulating the firm’s accounting records to make its financial performance look better than it really is. However, stockholders and portfolio managers, and especially investors who specialize in selling stocks short when they think the firm is overvalued, will be scrutinizing the records to detect phony accounting designed to mislead investors.
If it’s worth doing..
Eliminating pollution. Earning straight As. Being completely organized Cleaning your apartment until it sparkles. Making automobiles completely safe. Making airplanes fully secure against terrorist attacks. All of these are worthwhile goals, right? Well, they are until you consider the costs of actually achieving them. The heading for this post is of course, a play on the old saying, “If it’s worth doing, it’s worth doing to the best of your ability.” Economics suggests, however, that this is not a sensible guideline At some point. the gains from doing something even better will not be worth the cost It will make more sense to stop short of perfection.
As more resources are dedicated to an activity, the marginal improvements (benefits) will become smaller and smaller, while the marginal costs will rise. The optimal time and effort put into the activity will be achieved at Q2, and this will nearly always be well below one’s best effort. Note that inef-ficiency results when either too little (for example, Q,) or too much (for example, Q,) time and effort are put into the activity.
Do you make decisions this way? Last time you cleaned your car or apartment, why did you decide to leave some things undone? Once the most important areas were clean, you likely began to slup over other areas (like on top of the refrigerator or under the bed), figuring that the benefits of cleaning these areas were not worth the cost. Very few people live in a perfectly organized and clean house, wash their hands enough to prevent all colds, brush their teeth long enough to prevent all cavities, or make their home as Fort Knox. They recognize that the benefit of perfection in these, and many other areas, is simply not worth the cost.
Economics is about trade-offs; it is possible to pursue even worthy activities beyond the level that is consistent with economic efficiency. People seem to be more aware of this in their personal decision making than when evaluating public policy. It is not uncommon to hear people say things like, “We ought to eliminate all pollution” or “No price is too high to save a life.”