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The behavioural economics of executive incentives

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  • Pepper, Alexander

Abstract

The conventional design of executive compensation plans is based on an outdated model of executive agency. Behavioural economics has provided a better understanding of the relationship between executives’ pay and their motivation through detailed examination of the psychology of incentives. Four key points emerge from the research. First, executives are much more risk averse than financial theory predicts. Second executives are very high time discounters, thus reducing the perceived value of deferred rewards. Third, intrinsic motivation is much more important than admitted by traditional economic theory. Fourth, executives are more concerned about the perceived fairness of their awards relative to peers than in absolute amounts. Research suggests that companies would be better off paying generous salaries and using annual cash bonuses to incentivise desired actions and behaviours. Executives should be required to invest bonuses in company shares until they have sufficient ‘skin in the game’ to align their interests with shareholders.

Suggested Citation

  • Pepper, Alexander, 2020. "The behavioural economics of executive incentives," LSE Research Online Documents on Economics 106145, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:106145
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    File URL: http://eprints.lse.ac.uk/106145/
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    References listed on IDEAS

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    2. Pepper, Alexander & Gore, Julie, 2014. "The economic psychology of incentives: An international study of top managers," Journal of World Business, Elsevier, vol. 49(3), pages 350-361.
    3. Carola Frydman & Raven E. Saks, 2010. "Executive Compensation: A New View from a Long-Term Perspective, 1936--2005," The Review of Financial Studies, Society for Financial Studies, vol. 23(5), pages 2099-2138.
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    6. Pepper, Alexander & Gore, Julie, 2014. "The economic psychology of incentives: an international study of top managers," LSE Research Online Documents on Economics 51655, London School of Economics and Political Science, LSE Library.
    7. Pepper, Alexander & Gore, Julie, 2015. "Behavioral agency theory: new foundations for theorizing about executive compensation," LSE Research Online Documents on Economics 47569, London School of Economics and Political Science, LSE Library.
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    More about this item

    JEL classification:

    • R14 - Urban, Rural, Regional, Real Estate, and Transportation Economics - - General Regional Economics - - - Land Use Patterns
    • J01 - Labor and Demographic Economics - - General - - - Labor Economics: General

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