Question 4. Pay-for-performance is the basis of optimal contracting theory yet the managerial power approach claims...

Question 4.
Pay-for-performance is the basis of optimal contracting theory yet the managerial
power approach claims the relationship between executive pay and firm performance
has decoupled and is broken. Discuss.

Expert Solution

OPTIMAL CONTRACTING THEORY

Optimal contracting model describes the compensation for executives. As per this approach, the compensation is purely based on the performance of executives. That's why it is known as pay-for-performance approach. The optimal contract rewards the the good performance of the executives in an organisation. But the compensation of executives is seemed to be deviated from optimal contracting model. Because executives have substantial influence over their compensation. Managerial Power Approach discusses about it.

MANAGERIAL POWER APPROACH

As per this approach, the executive compensation is considered to be excessive when it is compared with the efficient compensation contract. The given statement is that Managerial Power Approach claims the relationship between executive pay and firm performance has decoupled and is broken. It means that there is no relationship between the executive pay and their performnace. The executives who are paid high may not be the top performers. MPA is not consistent with optimal contracting theory. This approach states that the executive compensation is a result of managerial power. MPA establishes a positive relationship between compensation and power.

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