Incentives in the Firm and the Roots of Capitalist Myopia

Abstract

Individual managers are the real actors, who shape market outcome through key decisions they take on behalf of firms. Their individual payoffs are determined by the internal incentive contracts of the firm, rather than the incentives originated purely in the marketplace. This paper explores the effect of such incentive contracts on the time horizon for decision-making by executives. Considering complex and multidimensional nature of executive job, the paper employs the Multitask Principal-agent approach developed by Holmstrom & Milgrom for developing model outlining the mechanism of such a choice. According to the model, a multitask agent subjected to a performance linked incentive structure maximizes his utility through reallocation of efforts towards the tasks with shorter payback period, even when the firm doesn't optimize its value due to such a choice. It also discusses why instead of mitigating the horizon problem, as predicted by the efficient market hypothesis, the excessive reliance on stock options in executive compensation design exacerbates horizon problem. Finally the paper describes the difference in mechanisms by which, earnings based cash incentives and stock options affect the decision horizon.