Some firms appear to structure their executives’ incentives as strategic weapons, designed to soften competition from industry rivals. In particular, firms incorporate revenue-based pay into their executives’ pay plans when doing so is most effective at making rivals back off. This approach to executive compensation is consistent with the theory of “strategic delegation,” and suggests that executive compensation plans play a key role in firms’ strategic positioning.

Background

How should performance be measured and rewarded? It’s a question that has fascinated economists, educators, consultants, and bosses for decades. Within the economics literature, the dominant perspective is that of a moral hazard framework, first formalized by Holmstrom (1979). Employees (“agents”) want to do whatever is in their best interest—shirk their difficult/unpleasant duties and/or extract personal benefits, all the while garnering as much compensation as possible. In contrast, bosses/owners (“principals”) want the agent to engage in productive activity to maximize firm profits/value—something the agent will only do insofar as it boosts their compensation. Viewed from this perspective, the purpose of a performance measurement system is to differentiate between productive and unproductive activity, so that productivity can be rewarded and encouraged. As such, the best compensation plan is that which elicits productive/profitable behavior as efficiently and effectively as possible. This framework has proven very powerful. In addition to being simple and intuitive, the moral hazard framework has demonstrated remarkable ability to explain observed compensation practices, both for rank-and-file employees, and for top-level managers and chief executive officers (“CEOs”). However, this framework does not fully explain the gamut of observed compensation practices.

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