Compensation and Incentives: Practice vs. Theory

38 Pages Posted: 24 Sep 1998

See all articles by George P. Baker

George P. Baker

HBS Negotiations, Organizations and Markets Unit; National Bureau of Economic Research (NBER)

Michael C. Jensen

Harvard Business School; SSRN; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI); Harvard University - Accounting & Control Unit

Kevin J. Murphy

University of Southern California - Marshall School of Business; USC Gould School of Law

Abstract

A thorough understanding of internal incentive structures is critical to developing a viable theory of the firm, since these incentives determine to a large extent how individuals inside an organization behave. Many common features of organizational incentive systems are not easily explained by traditional economic theory--including egalitarian pay systems in which compensation is largely independent of performance, the overwhelming use of promotion-based incentive systems, the absence of up-front fees for jobs and effective bonding contracts, and the general reluctance of employers to fire, penalize, or give poor performance evaluations to employees. Typical explanations for these practices offered by behaviorists and practitioners are distinctly uneconomic--focusing on notions such as fairness, equity, morale, trust, social responsibility, and culture. The challenge to economists is to provide viable economic explanations for these practices or to integrate these alternative notions into the traditional economic model.

JEL Classification: G31, G32, J31, J33

Suggested Citation

Baker, George P. and Jensen, Michael C. and Murphy, Kevin J., Compensation and Incentives: Practice vs. Theory. Michael C. Jensen, FOUNDATIONS OF ORGANIZATIONAL STRATEGY, Harvard University Press, 1998; Journal of Finance, Vol. 63, No. 3, pp. 593-616, July 1998, Available at SSRN: https://ssrn.com/abstract=94029 or http://dx.doi.org/10.2139/ssrn.94029

George P. Baker (Contact Author)

HBS Negotiations, Organizations and Markets Unit ( email )

Soldiers Field
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HOME PAGE: http://www.people.hbs.edu/gbaker/index.html

National Bureau of Economic Research (NBER)

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Michael C. Jensen

Harvard Business School ( email )

Soldiers Field
Negotiations, Organizations & Markets
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United States

HOME PAGE: http://drfd.hbs.edu/fit/public/facultyInfo.do?facInfo=ovr&facId=6484

SSRN ( email )

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National Bureau of Economic Research (NBER) ( email )

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European Corporate Governance Institute (ECGI) ( email )

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Harvard University - Accounting & Control Unit ( email )

Soldiers Field
Boston, MA 02163
United States

Kevin J. Murphy

University of Southern California - Marshall School of Business ( email )

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Los Angeles, CA 90089-0804
United States
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213-740-6650 (Fax)

USC Gould School of Law

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United States

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