Academic journal article Journal of Managerial Issues

An Integrative Model of Diffusion and Adaptation of Executive Pay Dispersion

Academic journal article Journal of Managerial Issues

An Integrative Model of Diffusion and Adaptation of Executive Pay Dispersion

Article excerpt

Executive pay dispersion has a significant impact on how top management teams (TMTs) function and how their organizations perform. On one hand, pay dispersion may have positive effects since it attracts more qualified applicants and retains competent employees (i.e., sorting effect) as well as motivates employees to make more effort (i.e., incentive effect) (Lazear and Rosen, 1981). However, pay dispersion can also result in undesirable results such as executive turnover and detrimental firm performance (Bloom and Michel, 2002). A firm with excessive executive pay dispersion may suffer from high executive turnover or lack of collaboration among TMTs (Messersmith etal., 2011). In opposition, a firm with lower executive pay dispersion than the optimal level may not reap the benefits from sorting and incentive effects. In this sense, as a critical incentive scheme, the level of executive pay dispersion is an important governance decision for a board of directors, especially compensation committee members.

The determinants of pay dispersion have been the subject of prior studies. For example, tournament theory (e.g., Lazear and Rosen, 1981) suggests that executive pay dispersion is the outcome of a series of tournament-like competitions for the higher position in the organizational hierarchy. Other studies (e.g., Fredrickson et al., 2010) argue that executive pay dispersion is influenced by the social comparison that occurs among TMT members. Despite this line of research, relatively little investigation has been undertaken to examine the effects of compensation committee members' socio-psychological processes, specifically how committee members anchor their decision-making on their own experiences. In other words, prior studies may have underestimated the influence of socio-psychological processes (i.e., diffusion and adaptation) because they were limited in focus to the tournament process or social comparison among TMT members. In response to the lack of research on socio-psychological perspective, this study provides an integrative model of executive pay dispersion determination: "inter-firm diffusion" and "intra-firm adaptation" executed by the compensation committee. Figure I visualizes this process.

Following Westphal et al. (2001), "focal firm" refers to a firm where an individual serves as a board of director's compensation committee member while "tied-to firm" refers to a firm where the same individual serves as an executive. Based on institutional theory (DiMaggio and Powell, 1983), this study proposes an inter-firm diffusion process: the executive pay dispersion of committee members' focal firms should be synchronized with that of their tied-to firms. In addition, based on group development framework, this study proposes an intra-firm adaptation process where the features of diffused pay dispersion are adapted through a collective decision-making process among committee members. This synchronization should be conditioned by how long committee members have worked together (i.e., shared tenure). Results from the sample of U.S. banks show that there is evidence of both diffusion and adaptation. In summary, this study contributes to the existing literature by proposing that executive compensation committees may engage in socio-psychological processes as they establish executive pay dispersion through both "inter-firm diffusion" and "intra-firm adaptation."


Role of Compensation Committee in the Diffusion Process

While tournament theory provides justification for executive pay dispersion in terms of sorting effect and incentive effect, the institutional perspective provides a theoretical explanation for the integrative model of diffusion of executive pay dispersion through compensation committees. Meyer and Rowan argue that "institutionalization involves the processes by which social processes, obligations, or actualities come to take on a rule-like status in social thought and action" (1977: 341). …

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