Towards a Bargaining Theory of the Firm

Abstract

This article models the long-term relationship between managers and shareholders as a multi-stage (repeated) bargaining game. In each stage of the game, the parties reach explicit and tacit bargains to divide two types of stakes: “substantive” or monetary stakes, such as dividends, retained earnings, and management compensation; and “procedural” stakes, which are bargains over the rules of the game applicable in future stages. The article shows that even a relatively small bargaining advantage by either managers or shareholders can greatly impact the governance institutions that emerge and survive within a particular corporation. It then argues that a variety of institutional features of modern public corporations give managers a great deal of bargaining power over both substantive and procedural stakes. This allows managers great leeway over their compensation packages in any one period and the ability to ratchet-up the bargaining power that they will enjoy in future periods – e.g., making it more difficult for shareholders to monitor and replace them. By focusing on the dynamic nature of corporate governance relationships, the bargaining model provides a novel explanation of the Van Gorkom decision, managerial entrenchment, and the general path-dependence of compensation practices within corporations.

Keywords: corporate governance, executive compensation, corporate law, public corporations

JEL Classification: G34, K22