Active agents, passive principals: does high-powered CEO compensation really improve incentives?

Dow, J and Raposo, C (2002) Active agents, passive principals: does high-powered CEO compensation really improve incentives? Working Paper. London Business School IFA Working Paper.

Abstract

In this paper we use agency theory to study the active role of the chief executive in the formulation of corporate strategy. Unlike traditional applications of agency theory, we allow the agent (CEO) to play a role in defining the parameters of the agency problem. We argue that CEOs will have an incentive to propose difficult, ambitious and opaque strategies. The effect arises because in equilibrium, the agent may be overcompensated in the sense that the participation constraint is not binding in determining his compensation. The agent can exploit this by proposing ambitious corporate strategies, thereby influencing the parameters of the constraints in the agency problem. The principal (the owners of the company) can mitigate this by precommitting to pay high compensation regardless of the manager's chosen strategy, but may prefer not to do so.