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Behavioural Agency Theory

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Book cover Agency Theory and Executive Pay

Abstract

This chapter explains that the conventional design of executive compensation plans, involving high salaries, generous bonuses, and highly leveraged stock programmes is based on an outdated set of assumptions about human behaviour and executive agency. It describes a revised theory of agency and a modified design framework for executive pay plans based on developments in behavioural science.

This chapter draws largely from Pepper, A. (2017). Applying economic psychology to the problem of executive compensation. The Psychologist-Manager Journal, 20(4), 195–207. The relevant parts are reprinted with the permission of the American Psychological Association.

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Notes

  1. 1.

    The extensive literature on the application of agency theory to executive compensation dates back to Jensen, M., & Meckling, W. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4). A helpful summary is provided by Eisenhardt, K. (1989) Agency Theory: An Assessment and Review, Academy of Management Review, 14 (1), 57–74.

  2. 2.

    In 1990, in an article entitled, “Performance pay and top-management incentives”, published in the Journal of Political Economy, Michael Jensen and Kevin Murphy were unable to find a statistically significant connection between CEO pay and performance. Ten years later Henry Tosi, Steven Werner, Jeffrey Katz, and Luis Gomez-Mejia, in “How much does performance matter? A meta-analysis of CEO pay studies”, in the Journal of Management, concluded that incentive alignment as an explanatory agency construct for CEO pay was at best weakly supported by the evidence based on their meta-analysis of over 100 empirical studies. In 2010 a literature review by Carola Frydman and Dirk Jenter entitled, “CEO compensation”, in the Annual Review of Financial Economics, concluded that neither agency theory nor the alternative “managerial power hypothesis” proposed by Lucien Bebchuk, Jesse Fried, and David Walker (2002) was fully consistent with the available evidence.

  3. 3.

    Wiseman, R., & Gomez-Mejia, L. (1998). A behavioral agency model of managerial risk taking. Academy of Management Review, 23 (1), 133–153.

  4. 4.

    Sanders, G., & Carpenter, M. (2003). A behavioral agency theory perspective on stock repurchase program announcements. Academy of Management Journal, 46 (3), 160–178.

  5. 5.

    Rebitzer, J., & Taylor, L. (2011). Extrinsic rewards and intrinsic motives: standard and behavioral approaches to agency and labor markets. In O. Ashenfelter & D. Card (Eds.), Handbook of Labor Economics (Vol. 4A, pp. 701–772). Amsterdam: North-Holland.

  6. 6.

    Pepper, A., & Gore, J. (2014). The economic psychology of incentives – an international study of top managers. Journal of World Business, 49(3), 289–464; Pepper, A., & Gore, J. (2015). Behavioral agency theory: New foundations for theorizing about executive compensation. Journal of Management, 41(4), 1045–1068; Pepper, A., Gore, J., & Crossman, A. (2013). Are long-term incentive plans an effective and efficient way of motivating senior executives? Human Resource Management Journal, 23(1), 36–51; Pepper, A., Gosling, T., & Gore, J. (2015). Fairness, envy, guilt and greed: building equity considerations into agency theory. Human Relations, 68(8), 1291–1314. Pepper, A. (2015). The Economic Psychology of Incentives – New Design Principles for Executive Pay. Basingstoke, UK: Palgrave Macmillan. Pepper, A. (2017). Applying economic psychology to the problem of executive compensation. The Psychologist-Manager, 20(4), 195–207.

  7. 7.

    Pepper & Gore (2015). For goal setting theory, see Locke, E., & Latham, G. (1990). A theory of goal setting and task performance. Englewood Cliffs, NJ: Prentice Hall.

  8. 8.

    See in particular Pepper and Gore (2014); Pepper et al. (2013); Pepper et al. (2015).

  9. 9.

    Voom, V., (1964) Work and Motivation. New York: Wiley; Steel.P., & Konig, C., (2006) “Integrating Theories of Motivation”, Academy of Management Review, 31 (4): 889–913; Ainslie, G., (1991) “Derivation of Rational Economic Behavior from Hyperbolic Curves”, American Economic Review, 81 (2): 334–340; Kahneman, D., & Tversky, A., (1979) “Prospect Theory – An Analysis of Decision Under Risk”, Econometrica, 47 (2): 263–29.

  10. 10.

    Conyon, M., Core, J., & Guay, G., (2011) “Are U.S. CEOs Paid More Than U.K. CEOs? Inferences from Risk-adjusted Pay”. The Review of Financial Studies, 24 (2): 402–438.

  11. 11.

    Pfeffer, J., (1998) “Six Dangerous Myths About Pay”, Harvard Business Review, 76: 106–120.

  12. 12.

    Frey , B., (1997) Not Just for Money, an Economic Theory of Personal Motivation, Cheltenham, UK: Edward Elgar Publishing; Frey, B., & Jegen, R., (2001) “Motivation Crowding Theory”. Journal of Economic Surveys, 15 (5): 589–611.

  13. 13.

    The most famous article about the impact of fairness motivation in the context of compensation is by John StaceyAdams entitled, “Inequity in social exchange”, found in L. Berkowitz (Ed.), (1965) Advances in experimental social psychology: Academic Press, New York. Other helpful references, in various academic traditions, include Festinger, L., (1954) “A Theory of Social Comparison Processes,” Human Relations, 7(2):117–140; Varian H., (1974) “Equity, Envy and Efficiency”. Journal of Economic Theory, 9(1): 63–91, and (1975) “Distributive Justice, Welfare Economics and the Theory of Fairness. Philosophy and Public Affairs, 4(3): 223–247; Fehr, E., & Schmidt, K., (1999) “A Theory of Fairness, Competition, and Cooperation”. The Quarterly Journal of Economics, 114(3): 817–868; Folger, R., & Cropanzano, R., (2001) “Fairness Theory: Justice as Accountability”, in J. Greenberg & R. Cropanzano (eds.), Advances in Organization Justice, Stanford, CA: Stanford University Press.

  14. 14.

    For more details of the research on fairness, see Pepper et al. 2015.

  15. 15.

    Locke, E., & Latham, G. (2002). Building a practically useful theory of goal setting and task motivation – a 35 year odyssey. American Psychologist, 57, 705–717.

  16. 16.

    Grossman, S., & Hart, O. (1983). An analysis of the principal-agent problem. Econometrica, 51(1), 7–45; Grossman & Hart (1983) Hart, O. (1995). Firms, contracts and financial structure. Oxford University Press.

  17. 17.

    Roberts, J. (2010). Designing incentives in organizations. Journal of Institutional Economics, 6 (1), 125–132.

  18. 18.

    Spence , M. (1973). Job market signalling. Quarterly Journal of Economics, 87 (3) pp. 355–374.

  19. 19.

    Heath, J., (2014) “The Uses and Abuses of Agency Theory”, in Morality, Competition, and the Firm – The Market Failures Approach to Business Ethics, New York: Oxford University Press.

  20. 20.

    The calculations in this section are based on Table 1 in Pepper (2017).

  21. 21.

    See Norges Bank Investment Management, Asset Manager Perspective 01|2017, “Remuneration of the CEO”, published April 7, 2017.

  22. 22.

    See Buffett, W., (2014) Berkshire Hathaway – Letters to Shareholders 1965–2013, Palo Alto, CA: Max Olson; and Buffett, W., (2014) The Essays of Warren Buffett – Lessons for Investors and Managers, Singapore, John Wiley & Sons.

  23. 23.

    Philip Hampton was quoted in the Financial Times on May 9, 2016 by Financial Editor Patrick Jenkins.

References

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    Article  Google Scholar 

  • Pepper, A., & Gore, J. (2014). The Economic Psychology of Incentives – An International Study of Top Managers. Journal of World Business, 49(3), 289–464.

    Article  Google Scholar 

  • Pepper, A., & Gore, J. (2015). Behavioral Agency Theory: New Foundations for Theorizing About Executive Compensation. Journal of Management, 41(4), 1045–1068.

    Article  Google Scholar 

  • Pepper, A., Gore, J., & Crossman, A. (2013). Are Long-Term Incentive Plans an Effective and Efficient Way of Motivating Senior Executives? Human Resource Management Journal, 23(1), 36–51.

    Article  Google Scholar 

  • Pepper, A., Gosling, T., & Gore, J. (2015). Fairness, Envy, Guilt and Greed: Building Equity Considerations into Agency Theory. Human Relations, 68(8), 1291–1314.

    Article  Google Scholar 

  • Rebitzer, J., & Taylor, L. (2011). Extrinsic Rewards and Intrinsic Motives: Standard and Behavioral Approaches to Agency and Labor Markets. In O. Ashenfelter & D. Card (Eds.), Handbook of Labor Economics (Vol. 4A, pp. 701–772). Amsterdam: North-Holland.

    Google Scholar 

  • Roberts, J. (2010). Designing Incentives in Organizations. Journal of Institutional Economics, 6(1), 125–132.

    Article  Google Scholar 

  • Sanders, G., & Carpenter, M. (2003). A Behavioral Agency Theory Perspective on Stock Repurchase Program Announcements. Academy of Management Journal, 46(3), 160–178.

    Google Scholar 

  • Spence, M. (1973). Job Market Signalling. Quarterly Journal of Economics, 87, 355–374.

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  • Wiseman, R., & Gomez-Mejia, L. (1998). A Behavioral Agency Model of Managerial Risk Taking. Academy of Management Review, 23, 133–153.

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Authors and Affiliations

  1. Department of Management, London School of Economics and Political Science, London, UK

    Alexander Pepper

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Pepper, A. (2019). Behavioural Agency Theory. In: Agency Theory and Executive Pay. Palgrave Pivot, Cham. https://doi.org/10.1007/978-3-319-99969-2_5

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