Shawn has a masters of public administration, JD, and a BA in political science.
Managerial power theory argues that executive compensation is often excessive when compared against a hypothetical, economically efficient compensation contract. The theory also argues that executive pay does not correlate to performance. In other words, high earners are not necessarily high performers.
Why Is It Important?
You may be thinking, 'so what? Why should I care?' The owners of a corporation are shareholders, but the shareholders of publicly held companies - the companies we can buy and sell on the stock market - do not control the business they own. In fact, it's entirely possible that the corporate officers who control the corporation don't even own a share of the company.
This disconnect between ownership and control poses a risk that the people who control the company may not have the same interests as the people who own the corporation. Thus, it's important that there are sufficient means of corporate governance, ensuring that the executives behave and act in the best interests of the shareholders.
Managerial theory posits that these managers may not necessarily do so. This conflict of interest may create poor decision-making such as seeking short-term gain regardless of long-term risks. We can see such poor decision-making in the decisions made leading up to the financial crisis of 2008, which lead to the Great Recession.
In a perfect labor market, prospective employers and employees meet in the marketplace to negotiate labor in exchange for compensation. The market is perfectly competitive, meaning that each party has equal and sufficient information to make efficient decisions, and there are sufficient competitors for both labor and employers that each party has equal bargaining power. In this situation, the market will dictate fair compensation in exchange for the labor - where the most compensation an employer will pay equals the least amount of compensation a prospective employee will take in exchange for his labor.
Managerial power theory holds that high-level executives have the power to establish unequal bargaining power, which creates market inefficiencies resulting in excessive compensation that doesn't relate to performance. The theory's general argument consists of two points. First, corporate executives have some degree of control of their board of directors. Keep in mind that the board sets executive pay. Second, corporate executives are able to leverage their power over their boards to obtain excessive compensation.
Three factors support the theory of management control over a board of directors.
- Nature of board elections. The way in which board members are selected gives management a degree of control. Unlike a typical democratic election, board elections often present no choices for shareholders - the number of candidates equals the number of open positions - and it's too expensive for shareholders to challenge the process. Management can exert control over board elections by influencing the nomination of candidates.
- Deferential directors. The outcome of director elections often produces a board that is predisposed to defer to executive decisions. Many directors are actually CEOs of other companies and are sympathetic to management. Some directors can even be inside directors who also serve as corporate officers, which creates an obvious conflict of interest regarding compensation and assessing executive performance. Celebrity directors, such as respected academics or retired politicians, may simply not have the expertise to effectively oversee the management. Additionally, directors get quite a bit of compensation and receive some nice perks for not much work and are predisposed not to risk their positions by creating conflict.
- Disparity of resources. Finally, even if a director wishes to challenge executive pay, it's often hard to do. Directors work part-time and lack the level of familiarity with the corporation that executives have. Additionally, executives can often put up roadblocks to hinder a director's effort to obtain resources and information to make informed decisions.
Managerial power theory argues that executive compensation is often excessive because managers have the power to unduly influence board of director decisions regarding their compensation. According to the theory, executive compensation does not correlate well with performance. This theory is important because it indicates a problem with corporate governance, which is meant to protect the interests of the owners of a corporation and ensure sound corporate decision-making. Three factors that create managerial power include the nature of board elections, the deferential nature of board members, and the fact that board members often have inadequate resources to challenge managerial decisions and assess performance.
Review the lesson to get an overall understanding of managerial power theory, and then be ready to:
- Point out the argument and importance of the managerial power theory
- Specify the two points of the theory's general argument
- List and provide details about the three factors that support the theory of management control over a board of directors
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