The Structure of Organizational Incentives

By Lambert, Richard A.; Larcker, David F. et al. | Administrative Science Quarterly, September 1993 | Go to article overview

The Structure of Organizational Incentives


Lambert, Richard A., Larcker, David F., Weigelt, Keith, Administrative Science Quarterly


663-691.

Gibbons, Robert, and Kevin J. Murphy 1990 "Relative performance evaluation for chief executive officers." Industrial and Labor Relations Review, 43: 30-51.

Holmstrom, Bengt 1979 "Moral hazard and observability." Bell Journal of Economics, 10: 74-91.

Holmstrom, Bengt, and Paul R. Milgrom 1991 "Multitask principal-agent analyses: Incentive contracts, Firms devote considerable resources to constructing managerial wage structures and assigning managers to hierarchical positions. While a wide array of theories from economics, sociology, and organizational theory have been proposed for understanding these organizational processes, relatively little empirical research has examined the ability of these alternative models to explain organizational incentives. Moreover, although there are numerous studies of chief executive officer (CEO) compensation, only a few studies focus on the compensation structure of middle-level executives and its relationship to upper-level executive compensation (Abowd, 1990; Leonard, 1990; Gerhart and Milkovich, 1990; Lambert, Larcker, and Weigelt, 1991; Fisher and Govindarajan, 1992).

Much of the economics-based research on organizational incentives uses formal (analytical) principal-agent models. Agency research is primarily theoretic and has largely addressed the design of optimal compensation contracts in highly stylized settings. Such research, while conceptually important, has produced few empirically testable insights into how firms manage their promotion policies or select the structure of compensation for the total organization (e.g., Antle and Smith, 1986; Lambert and Larcker, 1987; Gibbons and Murphy, 1990; Janakiraman, Lambert, and Larcker, 1992; Sloan, 1993). Recent research has begun to extend agency models to job design and hierarchy issues (Holmstrom and Milgrom, 1991; Milgrom and Roberts, 1992; Melumad, Mookherjee, and Reichelstein, 1992) and to examine the effects of managerial discretion in determining rewards and promotions (Demski and Sappington, 1992; Baker, Gibbons, and Murphy, 1993). In addition, the economic theory of tournaments by Lazear and Rosen (1981) and Rosen (1986) provides some explicit empirical predictions about the hierarchical structure of organizational pay.

Organization theorists have long argued that economic models are too constrained and that noneconomic factors critically affect managerial compensation processes (Baron and Cook, 1992). These researchers have developed a rich set of alternative models to explain compensation and promotion practices focusing on sociological phenomena, like the relationship between internal labor markets and social stratification (Pfeffer and Cohen, 1984; Baron, 1984), the effect of ownership and monitoring by external parties on compensation practices (Tosi and Gomez-Mejia, 1989; Finkelstein and Hambrick, 1989), social influence and managerial power (Allen, 1981; Wade, O'Reilly, and Chandratat, 1990), and social comparison theory (O'Reilly, Main, and Crystal, 1988). With the exception of innovative tests developed by O'Reilly, Main, and Crystal (1988) and Finkelstein and Hambrick (1988), however, prior research has not attempted to test the applicability of economic and noneconomic models of organizational incentives simultaneously.

The purpose of this paper is to provide insights into the internal compensation schemes selected by organizations by examining the applicability of several alternative theories, developed by both organizational theorists and economists, to observed managerial wage structures and the process of designing organizational incentives. We analyze compensation data that include not only the salary and annual bonus data used by prior researchers but also the major components of multiyear compensation contracts (stock options, performance plans, restricted stock, and phantom stock), so that we can compute a measure of total executive compensation, rather than the more limited cash compensation (or the sum of salary and annual bonus) used in virtually all prior work. …

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