The economic psychology of incentives new design principles for executive pay

The Economic Psychology of Incentives The Economic Psychology of Incentives New Design Principles for Executive Pay Alexander Pepper London School of Economics and Political Science, UK © Alexander Pepper 2015 Softcover reprint of the hardcover 1st edition 2015 978-1-137-40923-2 All rights reserved No reproduction, copy or transmission of this publication may be made without written permission No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6–10 Kirby Street, London EC1N 8TS Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988 First published 2015 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010 Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries ISBN 978-1-349-68142-6 ISBN 978-1-137-40925-6 (eBook) DOI 10.1007/978-1-137-40925-6 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin A catalogue record for this book is available from the British Library A catalog record for this book is available from the Library of Congress Contents List of Tables and Figures vi Preface and Acknowledgements vii Introduction Long-Term Incentive Plans 10 Behavioural Agency Theory 26 Risk, Uncertainty and Time Discounting 59 Intrinsic Motivation and the Crowding-Out Conjecture 86 Fairness as a Precondition for Profit Seeking 105 New Design Principles for Executive Pay 129 Appendix 1: Questionnaire Used in the Main Study 144 Appendix 2: Main Study Demographics 149 Appendix 3: Mathematical Proof of the Importance of Fairness in Teams 152 Future Research 154 Further Reading 157 References 160 Author Index 173 Subject Index 178 v Tables and Figures Tables 1.1 Definition of key terms 2.1 Key themes and exemplary quotes from the preliminary study 3.1 Assumptions about the nature of man under positive agency theory and behavioural agency theory 3.2 Overview of positive agency theory vs behavioural agency theory 4.1 Aggregate results of the main study 4.2 Country indices 4.3 Hofstede correlations 5.1 Work preference inventory – descriptive statistics and one-sample t-test 5.2 Intrinsic motivation scores 6.1 Predicted results in the second fairness dilemma 6.2 Results of the ultimatum gain 6.3 Estimating coefficients for envy 6.4 Distribution of results in Dilemma 7.1 New design principles for executive pay 22 34 54 69 73 77 102 103 113 117 119 121 133 Figures 3.1 3.2 3.3 5.1 6.1 7.1 An agent’s job performance and work motivation cycle Agents’ pay–effort curve Firms’ performance cycle Concepts of motivation Distribution of the results of the ultimatum game Summary and formal restatement of behavioural agency theory 7.2 Remuneration committee’s dilemma 7.3 The process of institutional change vi 48 49 52 95 115 131 137 141 Preface and Acknowledgements The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own Like the steward of a rich man they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company Adam Smith (1776) An inquiry into the nature and causes of the wealth of nations London: Strahan and Cadell Book V: Chapter 1: Part III Article “Of the Public Works and Institutions Which Are Necessary for Facilitating Particular Branches of Commerce” The pleasure which we are to enjoy in ten years hence, interests us so little in comparison with that which we enjoy today, the passion which the first excites, is naturally so weak in comparison with that violent emotion which the second is apt to give occasion to, that one could never be any balance to the other, unless it was supported by a sense of propriety Adam Smith (1759) The theory of moral sentiments London: Miller; Edinburgh: Kincaid and Bell Part IV: Chapter “Of the Beauty Which the Appearance of Utility Bestows Upon the Characters and Actions of Men” Adam Smith identified the agency problem in public corporations as long ago as 1776 in the Wealth of Nations, the first great specialist work of economics Yet Adam Smith was also a behavioural scientist, writing in 1759 in The Theory of Moral Sentiments about vii viii Preface and Acknowledgements motivation, loss aversion, fairness and inter-temporal choice, among other things.1 That agency problems in public companies still exist today, and that the kinds of incentive mechanisms advocated by scholars and implemented by practitioners have not achieved their objective of solving these problems, is surely not in dispute: even John Roberts, one of the world’s leading organisational economists and a well-known agency theorist, has commented that agency theory did not perform well during the financial crisis of 2008–10.2 Nevertheless, it would be unwise to insist that the principal–agent model is now so fundamentally flawed that it should be rejected in its entirety: agency theory comes from a long and highly reputable scholarly tradition which has, over the last 40 years, influenced management scholars and legal theorists, as well as economists The objective of this book is to propose a new version of agency theory which is built on more robust assumptions about human behaviour It develops a line of thinking whose origins can be traced back to an article written by Robert Wiseman and Luiz Gomez-Mejia which was published in the Academy of Management Review in 1998.3 My hope is that, by extending the theory and providing empirical evidence in its support, I might encourage other scholars to build on the behavioural agency model and test it with new data Ultimately, of course, my goal is to have an effect on management practice and to contribute new ideas about executive reward that business will support, which might also help to win back the confidence of the public in public corporations and their managers It would indeed be very disappointing if “negligence and profusion” were always to prevail in the management of the affairs of public companies This monograph brings together in one place the research I have carried out during the past six years with various collaborators and co-authors into what has become known as the “behavioural aspects of senior executive reward systems”, commencing with my doctoral thesis submitted under that title in part fulfilment of the Ashraf, N., Camerer, C., & Loewenstein, G (2005) Adam Smith, behavioral economist Journal of Economic Perspectives, 19(3), 131–145 Roberts, J (2010) Designing incentives in organizations Journal of Institutional Economics, 6, 125–132 Wiseman, R., & Gomez-Mejia, L (1998) A behavioral agency model of managerial risk taking Academy of Management Review, 23(1), 133–153 Preface and Acknowledgements ix requirements of the degree of Doctor of Business Administration (DBA), awarded by the University of Surrey in 2011 Various parts of this book have previously been published in academic journals and are reproduced here with permission of the co-authors and publishers of the respective journals Pepper, A., Gore, J., & Crossman, A (2013) Are long-term incentive plans an effective and efficient way of motivating senior executives? Human Resource Management Journal, 23(1), 36–51 Reproduced with the permission of John Wiley & Sons Pepper, A., & Gore, J (2014) The economic psychology of incentives – An international study of top managers Journal of World Business, 49(3), 289–464 Reproduced with the permission of Elsevier Pepper, A., & Gore, J (2012) Behavioral agency theory: New foundations for theorizing about executive compensation Journal of Management, t dx.doi.org: 10.1177/0149206312461054 Reproduced with the permission of Sage Publications Pepper, A., Gosling, T., & Gore, J (2015) Fairness, envy, guilt and greed: Building equity considerations into agency theory Human Relations, dx.doi.org/:10.1177/0018726714554663 Reproduced with the permission of Sage Publications Many people deserve recognition for their contribution to this work, foremost the co-authors of the journal articles around which the book is based, namely Julie Gore and Alf Crossman at Surrey Business School, University of Surrey, and Tom Gosling at PricewaterhouseCoopers in London Their contributions to the original articles are noted at the beginning of the relevant chapters Without their help and support this work would not have been possible Numerous others have contributed directly or indirectly to this book In addition to my co-authors, these include Jon Terry, Sean O’Hare and Gemma Carr at PricewaterhouseCoopers; Wida Amani, Rebecca Campbell and Lori Peterson at the London School of Economics (LSE); Tony Dundon of Human Resource Management Journal; Wayne Cascio of Journal of World Business; Patrick Wright of Journal of Management; and Mathew Sheep of Human Relations, along with eight anonymous reviewers References 167 Kets de Vries, M (2006) The leader on the couch Chichester: John Wiley & Sons Kets de Vries, M (2007) Coach and couch: The psychology of better leaders Hampshire: Palgrave Macmillan King, N (2004) Using templates in the thematic analysis of text In C Cassell & G Symon (Eds.), Essential guide to qualitative methods in organizational research (pp 256–270) London: Sage Publications Inc Knight, F (1921/2006) Risk, uncertainty, and profit New York: Cosimo Classics Kohn, A (1993) Why incentive plans cannot work Harvard Business Review, 71, September–October, 54–63 Korman (1971) Industrial and Organizational Psychology Englewood Cliffs, NJ: Prentice Hall Kreps, D (1997) Intrinsic motivation and extrinsic incentives American Economic Review, 87(2), 359–364 Kuhn, T (1962/1996) The structure of scientific revolutions (Third ed.) 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people Chicago: Bonus Books Inc Author Index Note: The locators followed by ‘n’ refer to note numbers Adams, J S., 14, 33 n.27, 43 n.59, 44, 45, 50, 106 n.8, 107, 108 n.18, 124, 126 Adler, M., 106 n.7 Ainslie, G., 13 n.10, 33 n.26, 39, 43 Akerlof, G., 14, 44, 56 n.82, 123 Alchian, A., n.5, 29 n.13, 125 Alderfer, C P., 89, 96 Amabile, T., 99–101, 104 Ambrose, M L., 88 n.10 Andreoni, J., 108 n.24 Ariely, D., 24 Arrow, K., 47 Boyd, R.,112 n.36 Bratton, W., 12 n.4 Bray, D., 92 n.24 Brown, M., 110 n.33 Bruce, A., 24 n.22 Buck, T., 24 n.22, 61 n.10, 80 n.36, 83 n.40 Buffett, W., 134–135, 143 Bunce, A., 15 n.19 Burnham, D H., 91 n.19 Byrnes, J., 78 n.33 Baars, B., 88 Balkin, D., 26 n.1 Barnard, C., 35 Baumol, W., 106, 108, 109, 110 n.31, 123 Bebchuk, L., 12 n.4, 26 n.1, 56 n.81, 60, 83 n.38, 139 Becker, G., 37 Berrone, P., 157 Besley, T., 12, 13 n.6, 40, 88 n.11 Bewley, T., 15, 108 n 25 Black, S., 64 n.18 Blau, P., 106 n.8, 108 Boivie, S., 40 Bolton, G., 108 n.24 Bond, M., 68 Bontempo, R., 68 Bottom, W., 68 Bournois, F., 21 n.21, 87 Bowie, N., 105 n.1, 106 n.6, 107, 128 n.61 Bowles, S.,112 n.36 Boxall, P., 37 Boyd, B., 62 n.12 Camerer, C., 28 n.11,112 n.36 Cannella, A., 28, 154, 158 Carpenter, M., 28, 36 n.33, 51 n.75, 52 n.76, 60 n.8, 128 n.60, 154, 157 Cascio, W., 64, 84 n.41 Champlin, D., 136 n.6 Charness, G., 108 n.24 Charreaux, G., 29 n.12 Christen, M., 30 n.16 Clark, K., 63 n.17 Cohen, G., 106 n.6, 107, 159 Collins, C., 63 n.17 Colquitt, J., 106 n.10, 108 n.19 Combs, J., 26 n.1 Cong, X., 98 n.42 Connelly, B., 105 n.1, 108 n.27, 125 n.50 Conyon, M., 65, 130 n.1 Core, J., 65 Crook, T., 105 n.1, 108 n.27, 125 n.50 Cropanzano, R., 106 n.10, 109 n.29 Croson, R., 78 173 174 Author Index Crossman, A., n.14, 36 n.34, 60 n.8, 63 n.15, 127 n.59, 128 n.60, 135 n.5, 136 n.7, 157 Crystal, G., 105 n.1, 126 n.56 Csikszentmihalyi, M., 94, 96, 100 n.47 Cuevas-Rodriquez, G., 60 n.7 Cycyota, C., 63 n.15 Cyert, R., 56 Freeman, R., 105 n.1, 106 n.6, 107, 128 n.61 Frey, B., n.3, 13, 28 n.11, 32, 40, 97, 159 Fried, J., 12 n.4, 56 n.81, 57 n.85, 83 n.38 Friedman, M., 2, 3, 57 n.85 Frydman, C., n.8, 27, 60 n.5 Fudenberg, D., 108 n.24 Daily, C., 109 n.28 Dalton, D., 109 n.28 Daniels, D., 92 n.23 Davis-Blake, A., 126 n.53 Dawes, R M., 92 n.25 deCharms, R., 94 n.33 Deci, E., 13, 32 n.23, 39, 40, 48, 93, 94, 96, 97 Demsetz, H., n.5, 29 n.13, 125 Deutsch, M., 106 n.8 Devers, C., 26 n.2 Di Maggio, P., 55 n.80 Diamond, P., 14 n.11, 112 Doldor, E., 15 n.18 Gangloff, K., 105 n.1, 108 n.27, 125 n.50 Gavetti, G., 56 n.84 Gayle, G., 60 Geletkanycz, M., 64 n.18 Ghatak, M., 12, 13 n.6, 40, n.11 Gintis, H., 112 n.36 Gneezy, U., 78, 97, 98 n.41 Gomez-Mejia, L., 15, 24 n.24, 27, 29 n.12, 42, 44, 60 n.8, 105 n.2, 128 n.60, 154, 157 Gore, J., n.14, 60 n.8, 127 n.59, 128 n.60 Gosling, T., n.14, 36 n.34, 60 n.8, 63 n.15, 127 n.59, 128 n.60, 135 n.5, 136 n.7, 157 Grant, R., 106 n.6, 107 Graves, S., 43 n.57 Greenberg, J., 106 n.10, 108 n.19 Greenbury, R., 10, 138, 139, 142 Greene, D., 32, 97 n.98 Greve, H., 56 n.84 Grinstein, Y., 60 Grossman, S., 45 n.65, 48 n.68 Groysberg, B., 93 n.27 Guay, W., 65 Guest, G., 15 n.19 Guth, W., 111 n.35 Eisenhardt, K M., 29 n.12, 29 n.14, 31, 53, 54, 57, 108 n.27, 157 Elster, J., 122, 158 Ezzamel, M., 110 n.33 Falk, A., 127 n.57, 128 n.62 Fehr, E., 15, 33, 44, 106, 108, 110, 112, 113, 116, 117, 118, 120, 122–8, 159 Fenton-O’Creevy, M P., 79 n.34, 87 Festinger, L., 106 n.8, 107, 125 Finkelstein, S., 27 n.3, 28, 51 n.75, 127 n.59, 154, 158 Folger, R., 106 n.10, 109 n.29 Foss, N., n.2, 31 n.20, 126, 127 n.57, 128 n.62 Franco-Santos, M., 157 Frankl, V., 96 Frederick, S., 43 n.57, 88, 90 Fredrickson, J., 126 n.53 Hall, B., 61 n.10, 79 n.35, 80 n.36, 81, 83 n.40 Hambrick, D., 28, 36 n.36, 51 n.75, 52 n.76, 126 n.53, 126 n.56, 154, 158 Hardy, C., 139 n.12 Harrison, D., 63 n.15 Author Index Hart, O., 45 n.65, 46 n.68, 116 Harzing, A., 63 n.16 Haslam, N., 13 n.10, 33 n.26, 39 n.46 Hastie, R., 92 n.25 Hatcher, L., 72 n.29, 142 Hausman, D., 109 n.30 Henderson, A., 126 n.53 Hennessey, B., 100, 101 Henrich, J., 112 n.36 Hens, T., 62 n.13, 75 n.30 Herzberg, F., 88, 90–1, 96 Hill, K., 100, 101 Hofstede, G., 68, 77 Holmstrom, B., 126 Homans, G., 106 n.8, 108 Howard, A., 92 n.24 Hsee, C., 68, 75 Hull, C L., 88 Huy, Q., 139 n.12 Iyer, G., 30 n.16 Jegen, R., 13, 28 n.11, 32, 40, 97 n.39 Jensen, M., 3, 26, 27 n.3, 29 n.12, 30,36, 56 n.81, 60 n.4, 157 Jenter, D., n.8, n.5 Johnson, L., 15 n.19 Kahneman, D., 3, 4, 13 n.10, 27 n.7, 39 n.45, 42, 75 n.31, 158 Kane, M., 98 n.42 Kaplow, L., 106 n.7 Kets de Vries, M., 92 King, N., 16 n.20 Knight, F., 68 Knoedler, J., 136 n.6 Kohn, A., 97 Kolditz, T., 98 n.42 Konig, C., 13, 38–9, 43, 57, 87, 159 Korman, A., 91 n.18 Kranton, R., 123 Kreps, D., 12, 40, 87 n.2 Kuhn, T., 4, 138, 139 Kulik, C T., 88 n.10 175 Lambert, R., 61 n.10, 80 n.36, 83 n.40, 125 n.50 Lange, D., 40 Larcker, D., 61 n.10, 80 n.36, 83 n.40, 125 n.50 Latham, G., 28 n.11, 45, 89, 92, 93 n.26, 158 Lawrence, P R., 93 n.27, 96 Lazear, E P., 26 n.1, 105 n.1, 125, 126 n.55 Le Grande, J., 88 n.11 Lee, L., 93, 96 Leibenstein, H., 3, n.10, 24, 32, 37, 61 Lepper, M., 32, 97 n.38 Leventhal, G., 106 n.8 Levine, D., 108 n.24 Levinthal, D., 56 n.84 Lewin, K., 37 Lindenberg, S., 108, 126, 127 n.57, 128 n.62 Locke, E., 28 n.11, 45, 92, 93 n.26 Loewenstein, G., 158 Maccoby, M., 92 Mackenzie, D., 109 Main, B., 24 n.22, 159 March, J., 56 Markowitz, H., 100 n.46 Marschak, J., 125 Martin, L., 30 n.16 Maslow, A H., 88 n.9, 89, 90, 91, 94, 96 Mason, P., 36 n.32, 51 n.75, 52 n.76, 158 McClelland, D C., 91, 92 McCullers, J., 98 n.43 McDonald, M., 40 McElreath, R., 112 n.36 McGregor, D M., 88 n.9, 90 Meckling, W., n.5, 29 n.13, 30, 60 n.4, 157 Meulbroek, L., 61 n.160, 80 n.36, 83 n.40 Michelman, F R., 15, 44 Miller, D., 78 n.33 176 Author Index Miller, J., 108 n.24 Miller, R., 60 Mintzberg, H., 47 n.72 Mitchell, T R., 92 n.23 Morris, T J., 87 n.3 Murphy, K., 3, 26, 27 n.3, 56 n.81, 60 n.5, 61 n.10, 79 n.35, 80 n.36, 81, 83 n.40 Nicholson, N., 79 Nohria, N., 93, 96 North, D., 140 Nowak, M., 113 n.39 Nozick, R., 106, 107, 159 O’Donoghue, T., 43 n.57 O’Reilly, C., 105 n.1, 126 n.56 Oberholzer-Gee, F., 97 Ocasio, W., 56 n.84 Ockenfels, A., 108 n.24 Omar, A., 98 n.42 Ouchi, W., 90 n.15 Page, K., 113 n.39 Pallant, J., 67 n.22 Pepper, A., n.14, 36 n.34, 60 n.8, 63 n.15, 127 n.59, 128 n.60, 135 n.5, 136 n.7, 157 Pettigrew, A., 63 Pfeffer, J., 97 Pinder, C C., 89, 91 n.18, 158 Pink, D., 93, 96, 159 Pisano, G., 52 Pollock, T.,26 n.1, 105 n.2 Popper, K., 83, 92 Powell, W., 55 n.80 Pratt, J., 32, 37 n.41, 157 Purcell, J., 37 Rabin, M., 4, 106 n.9, 108 n.24 Radner, R., 125 Rawls, J., 106, 107, 110, 124 n.46, 159 Rebitzer, J., 28, 60 n.8, 128 n.60, 154, 158 Reilly, G., 26 n.2 Rieger, M., 62 n.13, 75 n.30 Ringuest, J., 43 n.57 Riordan, C., 84 n.41 Roberts, J., 27, 46, 47, 52, 56, 60, 85, 107, 122, 127, 128 n.62, 139 n.11 Robertson, A., 122 Robertson, D., 64 n.18 Rosen, S., 26 n.1, 105 n.1, 125, 126 n.55 Ross Ashby, W., 47 n.71 Rustichini, A., 97 Rutherford, M., n.10 Ryan, R., 13, 32 n.23, 39, 40, 48, 93, 94, 96, 97 Saks, R., 27 Sanders, G., 28, 36 n.33, 51 n.75, 52 n.76, 60 n.8, 128 n.60, 154, 157 Santos, M., 62 n.12 Schafer, W., 78 n.33 Schaffer, B., 84 n.41 Schlegelmilch, B., 64 n.18 Schlicht, E., 105 n.2, 127 n.57, 128 n.62 Schmidt, K., 15, 33, 44, 106, 108, 110, 112, 113, 116–8, 120, 122–8, 159 Schmittberger, R., 111 n.35 Schwartz, B., 98 n.42 Schwarze, B., 111 n.35 Sealy, R., 15 n.18 Shafir, E., 14 n.11, 44 n.60, 112, 118 Shavell, S., 106 n.7 Shen, W., 62 n.12 Shuen, A., 52 Siegel, P., 126 n.53 Sigmund, K., 113 n.39 Simon, H., 2–4, 24, 27 n.3, 35 Skills, M., 26 n.1 Sliwka, D., 28 n.11, 32 n.23, 40 Soane, E., 79 Soberman, D., 30 n.16 Solow, R., 136 Spence, M., n.5, 46 Author Index Steel, P., 13, 38, 39, 43, 57, 87, 159 Steers, R., 26 n.1 Suddaby, R., 139 n.12 Taylor, L., 28, 60 n.8, 128 n.60, 154, 158 Teece, D., 52, 127 n.57, 128 n.62 Tesser, A., 30 n.16 Thaler, R., 24 Tighe, E., 100, 101 Tihanyi, L., 105 n.1, 108 n.27, 125 n.50 Tversky, A., 3, n.11, 13 n.10, 14 n.11, 27 n.7, 39 n.45, 42, 75 n.31, 112, 158 Tyson, S., 21 n.21, 87 177 Wade, J., 26 n.1, 105 n.2 Wakker, P., 57 Walker, D., 12 n.4 Wang, M., 62 n.13, 68 n.26, 75 n.30 Watson, R., 110 n.30 Weber, E., 68, 75 Weigelt, K., 61 n.10, 80 n.36, 83 n.40, 125 n.50 Westphal, J., 40 White, R., 94 n.33 Williamson, O., 2, 24, 31 n.20 Willman, P., 79 Wiseman, R., 15, 24 n.24, 26 n.2, 27, 29 n.12, 32 n.25, 42, 44, 60 n.8, 105 n.2, 128 n.60, 154, 157 Wrzesniewski, A., 98 n.42 Udueni, H., 24 n.22 Ungson, G., 26 n.1 Yellen, J., 14, 44 Yoder, M., 26 n.2 Varian, H., 106, 108, 109, 123, 159 Verrecchia, R., 61 n.10, 80 n.36, 83 n.40, 125 n.50 Vinnicombe, S., 15 n.18 Vroom, V H., 13, 38 n.42, 61 Zajac, E., 106 n.9 Zaleznik, A., 92 n.21 Zapata-Phelan, C., 106 n.10, 108 n.19 Zeckhauser, R., n.5, 32, 37, 41, 157 Subject Index Note: The locators followed by ‘n’ refer to note numbers agency theory as part of the modern theory of the firm, 56 behavioural assumptions, 12–15 criticisms, 128, 130 foundational assumptions, 139 origins, 3–4 predictive power, 128 principal–agent model, 12, 17, 23, 32, 53–4, 60, 107, 128, 139 research on, 4–7 shareholders, 1, 12 shortcomings, 60 see also behavioural agency theory; positive agency theory; principal-agent model; tournament theory annual bonuses, 17, 132–3 AT&T, 92 bankers’ pay, 139, 143 behavioural agency theory assessment criteria, 33–7 business performance, top managers, 51–2 CEO pay and stock price, 26–8 contracting, 45–7 goal-setting, 45–7 incentive design, 55–8 inequity aversion, 43–5 job performance, 47–50 monitoring, 45–7 prospect theory vs., 27 rationality, 31–3 re-theorising of agency theory, 24–5 risk, 41–2 shareholders, 27–8, 128 time differences, 43 unit of analysis, 33–7 work motivation, 37–41, 47–50 boards of directors, 1, 18, 83 bounded rationality behavioural agency theory, 31 definition, n.2, 8, 31 n.20 knowledge constraints, 47, 55 perceived value, 80 n.37 positive agency theory and, 29 n.14 time discounting and, 84 Brown, Gordon, 141 Cadbury code of corporate governance (1992), 142 chief executive officer (CEO) behavioural agency theory, 36 extrinsic rewards, 20 fairness perspectives, 20 financial incentives, 17 information economics perspective, 125 labour markets and, 137 on long-term incentive plans, 18 market forces, 135 pay and stock price, 3, 26–7 see also top-management team chief operating officer (COO), 9, 36 see also top-management team corporate performance, 36, 51–2, 58, 86, 129, 140 Department for Trade and Industry, 143 design principles, executive pay behavioural agency theory, 129–30 implications, 130–5 178 Subject Index new principles, 133 see also executive pay economic theory, 1–2, 13, 57, 108, 127, 135, 159 of fairness, 108 efficiency and effectiveness, 8, 35, 53, 54 entitlement theory, 107 see also Wilt Chamberlain argument equity theory, 20, 43, 52, 124 ERG theory, 89–90 executive labour market, 135–7, 142 executive pay agency theory and, 26 behavioural agency theory, 129–35 cross-national industry surveys, 63 fairness perspectives, 20, 127–8 impact of greed, 123 inflation, impact on, 59, 61, 82–3 institutional change, 140–3 market forces, impact on, 135–7 new design principles, 133 executive remuneration, 142–3 see also executive pay expectancy theory, 13, 21, 38, 43, 87 expected utility theory, 13 extrinsic motivation, 2, 7, 13, 19, 22, 28, 32, 37, 42–3, 49, 55, 86–8, 90, 93–4, 96–101, 103, 129–30, 154 fair-wage effort hypothesis, 14 fairness agency theory, 12 behavioural agency theory, 28 concept of, 106–9 definition, 109–10 economic model, 15, 106, 110–11 options, 117 pay and, 14, 20, 105, 128 perceived value, 130 refined model, 121–3 Fehr & Schmidt’s economic theory of, 120, 124 179 social comparisons, 21, 132 top-management team perspective, 125–6, 143 “fat cat” scandal, 138–9 financial crisis (2008–9), 60, 143 financial incentives, 3, 16–17, 21–2 financial theory, 39, 43, 76, 133 FTSE 350 companies, 10, 15, 100, 139 Furniss v Dawson 1984 (tax case), 141 Generally Accepted Accounting Principles (GAAP), 80–1 goal-setting theory, 45 greed, 106, 117, 121–6, 128 Greenbury report, 10, 138–9, 142 human capital theory, 26 hyperbolic discounting, 13, 39, 55, 62, 75, 82 inequity aversion, 15, 28 agents’ job performance and, 47–8, 52 behavioural agency theory, 29, 31 effort-to-pay ratio, 49–50, 55 equity theory, 43–5 fairness, 15, 28, 129 institutional theory, 26 International Financial Reporting Standard (IFRS2), 80 intrinsic motivation, 2, 7, 12–14, 19, 22, 24, 28, 32, 37, 49–50, 55, 65, 86–90, 93–4, 96–7, 99–101, 103–4, 129–30, 132, 154 Kuhnian theory of scientific revolutions, 139 London Stock Exchange, 16, 142 long-term incentives plans (LTIPs), 5, 9–11, 17–20, 22, 24, 50, 56, 59–64, 66–7, 72, 75–6, 78–9, 81–5, 132, 138–9 180 Subject Index motivation additional rewards and, 91 agency theory, 12 agent, 45–6, 49–50, 56, 58, 61, 81, 86–7, 129 behavioural agency model, 29, 54 bounded rationality, 84 contracting and, 46 concepts, 87, 95 corporate performance, 86 crowding-out conjecture, 97–9, 103 effort = drive x habit formula, 88 extrinsic, 2, 7, 13, 19, 22, 28, 32, 37, 42–3, 49, 55, 86–8, 90, 93–4, 96–101, 103, 129–30, 154 goal-setting theory, 45 information economics perspective, 126 intrinsic, 2, 7, 12–14, 19, 22, 24, 28, 32, 37, 49–50, 55, 65, 86–90, 93–4, 96–7, 99–101, 103–4, 129–30, 132, 154 job performance and, 37, 47–8, 51, 56, 58, 98 level of earnings vs., 15 LTIPs and, 11 needs theory, 90–1, 93 pay–effort function, 30, 50 personal characteristics, 91–2, 100 psychological theory of, 13 team, 126, 132 total level of, 13, 49, 97–9, 127 work, 12, 28, 31–2, 37–41, 47–8, 55, 57, 86 non-executives, 17, 20 personality theory, 91 political theory, 26 positive agency theory, 29–31, 39, 34, 43, 54, 57 principal–agent model, 1, 3, 12, 17, 23–4, 29 n 12, 32, 53–4, 60, 107, 128, 139 productive narcissists, 92 prospect theory, 13, 27, 38–9, 46, 57, 62, 75, 82, 130 psychoanalytic theory, 92 Ramsay v Inland Revenue Commissioners (1982 tax case), 141 rational choice theory, 83, 116 remuneration, 17, 20, 101, 125, 135–6, 139–40, 142–4 Reuters Group plc, 10, 138 risk, 3, 11, 14, 21, 24, 27–9, 31–4, 38–9, 41–2, 47–9, 55, 61–2, 67–8, 75–9, 81–4, 111, 123–4, 130–1, 134, 137, 143 senior executives actual pay, 50 behavioural agency theory, 32, 36 cross-national industrial survey, 63, 84 definition, economic model of fairness, 105–6, 120, 123, 127–8 financial incentives, 17, 21 form of compensation, 85 from FTSE 350 companies (empirical research), 15, 100 goal-setting theory, 45 inequity aversion, 15, 44 labour market, 135–7 long-term incentive plans (LTIPs), 10–11, 14, 20, 61–3, 72, 75, 79–80 motivating factors, 19, 22–4, 82, 87, 92, 100–1, 104 performance-related pay, 132 positive agency theory, shareholders and, 5, 28 top pay, comparisons, valence, 81 see also top management team Subject Index 181 shareholders agency theory and, 1, 12 behavioural agency theory and, 27–8, 128 executive compensation and, 56 long-term incentive plans (LTIPs) and, 5, 11, 17, 19, 60–1, 81–3 stakeholders vs., voting rights, 143 Warren Buffett’s letter to, 134–5 short-term incentives, 17–8, 132–3 see also annual bonuses social comparison theory, 107 “starving artist syndrome”, 89 top-management team behavioural agency theory, 86, 129 corporate performance, 86, 129 definition, equity considerations, 105 fairness perspectives, 125–8, 143 labour markets vs., 137 motivation, 127–8, 132 pay differentials, 132, 137 rewards and incentives, 105–6, 121 total shareholder return (TSR), 18–19, 22, 70 tournament theory, 7, 26, 105, 108, 125–6, 128, 130, 139 tax anti-avoidance rules, 141 avoidance, 140–2 evasion, 140, 142 laws, 5, 142 temporal motivation theory, 13, 38 see also expectancy theory termination payments, 143 thematic apperception test (TAT), 92 Theory X and Theory Y, 90 Theory Z, 90 n.15 time discounting, 29, 31, 33, 47–9, 61–2, 65, 68, 76–7, 80, 84, 130 ultimatum game, 111–20 uncertainty, 1, 14, 24, 31–2, 38–9, 42, 48, 53, 55, 61–2, 65, 67–8, 72, 75, 80–2, 84, 130 US Financial Accounting Standard (FAS) 123, 80 valence, 38–9, 61–2, 68, 72, 75, 81–2, 129–30 Wilt Chamberlain argument (entitlement theory), 107 work motivation, 13, 37, 47–8, 57, 88 .. .The Economic Psychology of Incentives The Economic Psychology of Incentives New Design Principles for Executive Pay Alexander Pepper London School of Economics and Political... that the lack of realism in some of their assumptions does not in itself undermine the scientific validity of their theories Milton Friedman famously wrote that the test of a good economic theory... in the Journal of Management in 2012, and which forms the basis of Chapter The ideas in Chapters and also owe much to the thesis which I submitted in part fulfilment of the requirements of the