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Managerial Power Theory: Overview

Instructor: Shawn Grimsley
Managerial power theory attempts to explain high executive pay. In this lesson, you'll learn what it is and discover its key concepts. You'll also have a chance to take a short quiz after the lesson.

Definition

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.

Key Concepts

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.

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