Incentives, Rationality, and Society
Michael Brennan (UCLA)
Printed in the New Corporate Finance by Donald Chew
Based on speech given at University of Maryland April 2, 1993
Executive Summary:
People do not always behave rationally. This is the counter argument to the Jensen Theory of man paper as well as the Murphy-Jensen school of thought on executive compensation.
The paper is full of Interesting stories!
Brannen tells the story of 2 regiments in Korean War. One with slack discipline was crushed by the Chinese, the other with strict discipline, performed much better. Author stresses that if soldiers were acting rationally, the discipline of generals would not be needed.
The author notes that generals do not have incentive pay but perform hard. We do not pay Doctors more for successful surgery. Yet we do for managers, Why?
The author frequently cites the writings of Adam Smith and tries to show that he did not mean to say that people should ONLY look out for themselves and that too heavy of reliance on a rational view of human nature might be too much. Further, he also quoted Smith: "it is the great precept of nature to love ourselves only as we love our neighbor." Thus can not rely totally on self-interest in pay.
"Postrel and Rumelt (1992) claim that incentive design must therefore have two components: first, rational preference alignment….Second, impulse control, which requires positioning the time and context to maximize their behavior modifying effects. (In the vernacular, you must do more than just pay people for performance.)
"The Economic man lacks both virtue and (most) vice. While he is never resentful at being treated unfairly, he is never angry at the unfair treatment of others. While he is never discouraged by failure, he will never perform without incentives….He has no honour or self-esteem, and feels no shame or pride in accomplishment." The paper then cites antidotal evidence that if employees are paid for performance they will come to expect it and, in the spirit of Maslow, and that as wealth increases non-economic (i.e. non cash) pay matters more.
Paper purports that ex-post bonuses (like grants to Generals) may be optimal due to the difficulty of writing explicit contracts. Thus, as Graef Crystal (1991) wrote, managerial compensation is at least in part a reward for past performance and in part for risk-taking. Paper also echoes John and John who point out that there are many stakeholders and by aligning incentives of Managers too closely to Shareholders, the value of the firm will be reduced.
In a final criticism, the paper points out the obvious problem that can arise when managers are paid for accounting income etc. (It must be market-based). The author concludes by saying that when teaching executive compensation and the Theory of Man, the fact that people are people, and not models must be considered and recognized. (Summarizer's Note: I am sure any teacher would stress that models are not meant to be perfect.)
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