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Corporate Governance and Managerial Compensation

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Amajor responsibility of the board of directors is to determine managerial compensation systems. How should managers be compensated? Should pay be tied to performance? How should performance be measured? What evidence is there about the relation between managerial pay and performance? What pay, performance evaluation, and compensation systems are likely to mitigate and not exacerbate conflicts of interests between managers and shareholders?

Consider a New Hampshire ski resort, SkiTrails, that is publicly owned. Ownership is dispersed, and the resort is run by a manager. In this arrangement, the manager is the agent of the owners, who want the manager to maximize the market value of SkiTrails. If the owners could directly observe the manager's day-to-day effort and had as much information as the manager about why the financial performance of Ski-Trails was good or bad, they could simply pay the manager a fixed wage and fire him if he shirked, consumed perquisites, or lacked the necessary skills for successfully managing the enterprise. The problem, however, is that the owners cannot directly observe the manager's efforts and that the manager typically has more information than the owners about why SkiTrails is or is not profitable. So, what can the owners do to solve this informational asymmetry problem and get information about whether the manager is putting out adequate effort, where adequate means managing effectively, not shirking, and adding value to the company.

One way to deal with this problem is to tie the manager's compensation entirely to an output measure—let's say profits. For example, the SkiTrails manager could be paid 10 percent of the resort's yearly profits. But this pay scheme creates an additional problem.
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Document Type: Research Article

Publication date: February 25, 2003

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