4/20/00

Michelle Mosman, the Stanford Institute for Economic Policy Research (650) 725-1874

Executive compensation: why companies pay the way they do

Is executive pay linked to the performance of the firms executives control? Yes, but only in good years, according to a study released Thursday by Scott Wallsten, a research fellow at the Stanford Institute for Economic Policy Research (SIEPR).

One reason, says Wallsten, who is also an acting assistant professor of public policy, is to align executives' incentives with those of shareholders. Without risk-taking on the part of management, companies would stagnate and would be uncompetitive.

In his new study, "'Executive Compensation and Firm Performance: Big Carrot, Small Stick," Wallsten notes that the incentive to "go for the gold" is hampered if executives fear their salary and benefits will suffer. In other words, he says, it's logical that they would be less likely to take necessary risks if they were worried about being punished for taking good risks that didn't pan out.

Wallsten first wrote about executive compensation for the Clinton Administration when he was a staff economist at the Council of Economic Advisers. Theory about risk-taking developed by the late Amos Tversky of Stanford and Daniel Kahneman of Princeton predicts that "losses loom larger than gains" in people's minds when they are making decisions under conditions of uncertainty, but previously, there had not been any empirical tests of this point in the case of executive compensation.

Wallsten has been at Stanford for the past year where he is working on a number of other studies, including one on Silicon Valley and its clones and another on telecommunications reforms in developing countries.

The Stanford Institute for Economic Policy Research (SIEPR), which was created in 1982, supports collaborations among economic researchers, business leaders and government officials. SIEPR's goal is to foster and support innovative, pragmatic economic research yielding results useful to policymakers. Topics studied at SIEPR include: economic growth, technology policies, environmental and telecommunication regulation, tax reform, corporate governance strategies, international trade agreements, exchange rate uncertainty and stock and market volatility. SIEPR conducts seminars, conferences and workshops exploring current events, business strategies and the consequences of economic policy for American business.

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