Performance Incentives within Firms : The Effect of Managerial Responsibility

Empirical research on the principal-agent model has focused almost exclusively on the incentives provided to chief executive officers. However, the model is also directly relevant to the incentives provided to other top executives. Furthermore, the extent to which other executives will be provided with high-powered incentives to maximize firm profits depends critically on the other measures of their performance that are observable to the shareholders. Top managers who have important divisional responsibilities within the firm have more precise signals of their effort than the overall performance of the firm. Consequently, the compensation of this group of executives will be less sensitive to firm performance than will the compensation of top managers with broad oversight authority. We find robust empirical support for this proposition using a comprehensive panel dataset of executives at large corporations. We also show that the aggregate pay-performance sensitivity of the top management team is quite substantial. These findings are consistent with a principal-agent model in which shareholders optimally utilize multiple signals of executive effort in determining compensation. Our results suggest that the principal-agent model is an appropriate characterization of the internal organization of the firm