Setting the CEO’s Pay: Economic and Psychological Perspectives

To many, the principal-agent model is the obvious lens through which executive pay should be viewed. Such a sentiment sits uncomfortably with a large number of empirical studies suggesting that the process of determining executive pay seems to be more readily explained by recourse to arguments of managerial power and influence. This paper investigates the micro-underpinnings of boardroom behavior in order to explain this departure from principal-agency theory’s argument that executive compensation serves to align interests between the owners of the company and its senior managers. Using data drawn from two very different industries, this study empirically demonstrates the linkages between the social forces present in the boardroom and executive pay outcomes. In particular, we find that there are strong interaction effects among social influence variables and the social setting of boardroom activity. Generous pay awards, bearing only a weak connection to corporate performance, are explained in the context of the social psychology of the boardroom. Although there is a price to be paid for engendering an atmosphere in which advice and counsel can flourish, the slippage from the idealized principal-agent prescription of pay for performance need not be overwhelmingly large.

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