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...ncy problem and executive compensation are linked. Among financial economists, the dominant approach to the study of executive compensation views managers’ pay arrangements as a (partial) remedy to the agency problem. Under this approach, which we label the “optimal contracting approach,” boards are assumed to design compensation schemes to provide managers with efficient incentives to maximize shareholder value. Financial economists have done substantial work within this optimal contracting model in an effort to understand executive compensation practices; recent surveys of this work include Murphy (1999) and Core, Guay and Larcker (2001). To some researchers working within the optimal contracting model, the main flaw with existing practices seems to be that, due to political limitations on how generously executives can be treated, compensation schemes are not sufficiently high-powered ( Jensen and Murphy, 1990). Another approach to studying executive compensation focuses on a different link between the agency problem and executive compensation. Under this approach, which we label the “managerial power approach,” executive compensation is viewed not only as a potential instrument for addressin...

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...is “rational choice” view is increasingly reflected in management practice—for example, the fraction of executive compensation that is tied to stock price has increased dramatically in recent decades =-=[9, 10]-=-— and has also been supported by a small number of field studies. Most notably, Lazear [8] conducted a study of a large “autoglass” factory in which workers installed windshields on a production line ...

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...2002; Hall and Liebman, 2000; Perry and Zenner, 2001). We are skeptical of this explanation because the explosion in grants of stock options was already underway in the 1980s (Hall and Liebman, 1998; =-=Murphy, 1999-=-) and because the law only applies to the top ve executives, who in turn account for only about 10 percent of all option grants. However, the new rule constituted an implicit government “blessing” of...

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...o the properties of observed contracts correspond to those that the currently standard models of contract theory predict? This new formulation makes it clear that a negative answer may only be temporary, as better models with new predictions are developed (ideally, in response to such rejections of currently standard models). 3.1 Static, complete contracts 3.1.1 Managerial Pay The standard model of moral hazard implies that managers’ pay should be sensitive to their …rms’ performance. The “pay-performance sensitivity” has been estimated by many papers (for a recent survey of the evidence, see Murphy (1999)). The seminal contribution is that of Jensen-Murphy (1990); using data on CEOs of US …rms from 1969 to 1983, they obtained what seemed to be very low estimates of the elasticity of executive compensation to …rm performance. Their oft-quoted result was that when the …rm’s value increases by $1,000, the (mean) manager’s wealth only increases by $3.25. 20 The early reaction to Jensen and Murphy’s result was that they indicated ine¢ciently low incentives for top management (see for instance Rosen (1992)). However, Haubrich (1994) showed that even fairly low levels of manager’s risk aversion (such...