How Well Does Agency Theory Explain Executive Compensation?

36 Pages Posted: 20 Jul 2018 Last revised: 19 Mar 2020

See all articles by George-Levi Gayle

George-Levi Gayle

Washington University in St. Louis - Department of Economics; Federal Reserve Banks - Federal Reserve Bank of St. Louis

Chen Li

New York University (NYU) - New York University (NYU), Shanghai

Robert A. Miller

Carnegie Mellon University - David A. Tepper School of Business

Date Written: 2018

Abstract

As the share of all income going to the top 1 percent has risen over the past four decades, so has the share of top incomes coming from labor income relative to capital income. The rise in labor income is mainly due to the explosion in executive compensation over the same period—mostly because of the increase in executives being paid with stocks, options, and bonuses. The principal-agent model explains the reason for such compensation instead of a flat salary. Yet hundreds of papers in economics, finance, accounting, and management have reached no consensus on whether executive compensation is efficient or whether empirically it conforms to the prediction of the principal-agent theory. In this article, we argue that this lack of consensus is due to two issues: The first is a measurement issue, and the second is that the exact prediction of the principal-agent model depends on many objects unobservable to the econometrician. We illustrate how using theory-based estimation together with a model-motivated measure of total compensation can help overcome these issues. Finally, using a model-consistent measure of compensation and theory-based estimation, we conclude that executive compensation broadly conforms to the principal-agent theory; however, each situation and the variables used have to be carefully modeled, identified, and estimated.

JEL Classification: D82, L25, M12, M52

Suggested Citation

Gayle, George-Levi and Li, Chen and Miller, Robert A., How Well Does Agency Theory Explain Executive Compensation? (2018). Review, Vol. 100, Issue 3, pp. 201-36, 2018, Baruch College Zicklin School of Business Research Paper No. 2018-07-01, Available at SSRN: https://ssrn.com/abstract=3217032 or http://dx.doi.org/10.20955/r.100.201-36

George-Levi Gayle (Contact Author)

Washington University in St. Louis - Department of Economics ( email )

One Brookings Drive
St. Louis, MO 63130
United States

HOME PAGE: http://https://artsci.wustl.edu/~ggayle/

Federal Reserve Banks - Federal Reserve Bank of St. Louis ( email )

P.O. Box 442
St. Louis, MO 63166-0442
United States

Chen Li

New York University (NYU) - New York University (NYU), Shanghai ( email )

1555 Century Ave
Shanghai, Shanghai 200122
China

HOME PAGE: http://sites.google.com/view/chen-li

Robert A. Miller

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

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