Abstract

Much of the discussion in finance and management employs agency theory and assumes a linear relationship between performance-based compensation and properly motivated executives. We believe that prospect theory serves as a better foundation to examine this relationship for three primary reasons. First, prospect theory holds that people overweight outcomes that are considered certain relative to outcomes that are merely probable. Second, prospect theory also holds that people shift reference points in many cases, again possibly leading executives to reduce risk-seeking behavior. Third, prospect theory also helps to explain that executives may be given an incentive to manage earnings. Based on the application of prospect theory, we propose the level of incentive-based compensation of CEOs has a nonlinear (concave) relationship with firm performance in the overall sample (H1). Then, we divide the sample in small and large firms as well as low-tech and high-tech firms. We assert that small firms must use more incentive-based compensation (H2) because they often can not compensate top executives with salaries that are competitive with those offered by larger firms. Likewise, high-tech firms must use more incentive-based compensation (H3). High-tech firms compete in industries that usually exhibit highly volatile returns (Liu, 2006; Wang & Maio, 2005; Ciccone & Rocco, 2005) preventing them from offering competitive levels of guaranteed pay to top executives although actions of the top executives can be expected to have a more significant impact on firm performance when volatility is high.

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