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.
Incentives, cooperation and the nature of the firm (1)
In capitalist countries, most firms are privately owned. Owners risk their wealth on the success of the business. If the firm is successful and earns profits, these financial gains go to the owners. Conversely, if the firm suffers losses, the owners must bear the consequences. Because the owners receive what remains after the revenue of the firm is used to pay the contractual costs, they are called residual amiantus.
In a market economy, the property right of owners to the residual income of the firm plays a very important role: it provides owners with a strong incentive to organize and structure their business in a manner that will keep the cost of producing output low (relative to its value). The wealth of these residual claimants is directly influenced by the success or failure of the firm. Thus, they have both the authority and a strong incentive to see that resources under their direction are used efficiently and directed toward production do goods that are valued more highly than their costs.
In principle, all production could be accomplished solely through contracting. For example, a builder might have a house built by contracting with one person to pour the concrete, another to construct the wooden part of the house, a third to install the roofing, a fourth to do the electrical wiring, and so on. No employees would have to be involved in such a project. More commonly though, goods and services are produced with some combination of contracting and the use of team production by employees of a firm.
Why do firms use team production? If contracting alone is used to produce some- thing, the producer must, for each project, (1) determine what needs to be produced and how, given the circumstances, current technology, and prices, (2) search out reliable suppliers, and (3) negotiate and enforce the contracts. The entrepreneur who wants to produce by this method must have specialized knowledge in a variety of areas and must devote a great deal of time and effort to the planning and contracting processes. Not many people have the expertise or the time to perform all these tasks by themselves except on a small scale. Team production for certain tasks can be more practical and less costly.
Accordingly, a builder with multiple projects is likely to hire knowledgeable, experienced workers to plan the construction process, purchase materials, and build the structures. The builder will then contract with others to obtain materials and more specialized labor services.