The effect of monetary compensation in managers’ behavior

Introduction

Behavioral Economics is the combination of Psychology and Economics that investigates what happen in the markets in which participants display human limitations (Mullainthan, 2000, p. 1) through the assessment of the intrinsic motivation of those people. This perspective can be considered to understand how socialization, networks and identity shape individual behaviour in organizations.

The objective of this paper is to analyze the effects of monetary compensation in the behavior of managers by using the Behavioral Economics’ approach to organizations, and then, to demonstrate that current schemes of compensation sometimes causes “irrational” decisions (from an economic perspective) that sabotage the performance of the firm.
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This work is divided in three parts: in the first part I explain the nature behind the behavior of managers, by describing the fact that corporations are compounded by individuals (including managers) with different goals and by developing the concept of principal-agency relationship; in the second part, some compensation schemes have been developed as well as their justification; in the third part, I analyze how the economic packages sometimes fail in their intent to drive the behavior of managers towards the performance of the firm; and in the last part, I comment some complementary alternatives to fix problems related to compensation, that are actually ineffective.

1. The nature of managers behind the behavior

2.1. The goals in organizations

When academics talk about the main organization’s goal, the first idea that comes to their heads is “increasing profits”, as if a company was a person with its own motivations. In spite of the legal fiction to attribute to the corporation the characteristics of a single entity, the reality is further complex. Actually, a corporation is composed by a variety of individuals (managers, employees, shareholders) with different interests than that of the organization; moreover, according to Williamson, there are also immediate determinants of individual behaviour within a firm: salary, security, prestige, power, professional excellence, social service, etcetera (Baxter, 1993, p. 160). If we recognize that different sub-goals of a firm (production, sales, inventories, market share, profit) are concerns of different people, the nature of a firm become even more difficult to define.

Even though organizational goals are distinct from the goals of individuals, they are not divorced: conflict of interests is a characteristic of the firms (Baxter, 1993, pp. 156-157). So, when we are dealing with organizations, we must explain organizational behaviour in terms of the goals of the individual in order to fit them in the organizational goals (Baxter, 1993, pp. 158-159).

In this context, companies should consider personal motivation of managers when develop its owns: (i) psychologically , manager don’t see firm as mere apparatus for satisfying their own desires, they go deeper and see the prosperity and success of the firm as an actual proxy for their desires; (ii) from a sociological perspective, managers want not only “narrow” economic gain but also achievement, power and status; (iii) from a economic point of view, managers ask for basic compensation, bonuses, stock options and other ways of compensation (Baxter, 1993, p. 161). Considering these ideas, managers’ primary goal is the maximization of the rate of growth of their firms, subject to the constraint imposed by a security factor (keep their jobs in the same or better conditions).

2.2. Principal-agency theory applied to firms

An agency relationship is defined as an exchange relation between a person (the principal) who delegates in another person (the agent) certain task to be perform in the interest of the first. The reason for the existence of this kind of relationship is due the lack of resources,