Question

executives remuneration is often used to manage the angency problem
how this is done and the potential pitfalls a firm face in trying to use remuneration to deal with the problem

Answer 1

Executive remuneration can be systematically used to manage the agency problem. The remuneration for managers like CEO, CFO etc. should be linked to the performance of the company and by doing this interest of the shareholders (i.e. owners) gets aligned with the interest of the managers and executives (i.e. the agents). For instance when executive are paid stock options or when the annual bonus of the executives are tied to stock performance of the firm then executives will automatically work in a manner that will be more aligned to the interest of the owners or the shareholders. In such a case managers will look to create the maximum value and will take decisions that will lead the stock price of the form to increase. This is known as the pay for performance relation.

The potential pitfalls that a firm may face in trying to use remuneration to deal with the problem are several. First of all it may give rise to managerial power approach. Secondly it may even give rise to rent extraction as well. In case of managerial power approach the board will not operate at arm’s length while devising the compensation arrangement of the executives. Secondly the desire to cover rent extraction will lead to pay arrangements that are inefficient and hence provides suboptimal incentives to the executives. As such sometimes power of managers will enable them to look for ways to compensate themselves which might not necessarily be consistent with the performance of the firm.