Crowding Theory and Executive Compensation

Abstract

Payment for performance is widely embraced as a key component of any well-designed executive compensation package. There is a price to be paid, however, for the heavy reliance on incentives as a way of controlling agent behavior. In particular, evidence exists demonstrating that incentives can crowd out an agent’s social preferences towards her principal. Social preferences are pro-social tendencies of people to do things for others for reasons such as fairness, reciprocity, altruism, and ethical or moral beliefs. The use of incentives in compensation can result in self-interested agents. When crowding out occurs, in order to elicit the desired level of performance, principals may need to increase the level of incentive employed. Crowding out therefore provides an additional account for rising levels of executive compensation. In addition, crowding theory can provide a helpful explanation for the tension around the U.S. government’s reaction to preexisting banker incentive contracts during the 2008 financial crisis.