Coase-Sandor Working Paper Series in Law and Economics

Publication Date

2004

Publication Title

Law & Economics Working Papers

Abstract

We argue that firms undertake to reduce employee savings in order to avoid final period problems that occur when employees accumulate enough wealth to retire and leave the industry. Normally, reputation constrains employee behavior, since an employee who "cheats" at one firm will then find herself unable to get a job at another. However, employees who have saved such that they no longer care about continued employment will act opportunistically in the final periods of employment, which can destroy much or all of the surplus otherwise created by the employment relationship. We believe that this sort of final period cheating creates significant problems for employees in positions of delicate trust, particularly those with a large variable compensation component, such as corporate CEOs, securities professionals, and even corporate lawyers. Payment in-kind (perks), deferred compensation (corporate loans), and the encouragement of employees' conspicuous consumption—either through screening, inculcation, or signaling—are strategies that firms enact to combat this final period problem of employee cheating. Employees who reduce savings are more reliable over the long term than employees who do not, since reduced savings makes employees more dependent upon remaining employed into the future; these employees will invest in their reputations by engaging in less cheating. We make an analogy to drug dependency: the employee who consumes all her resources immediately enjoys large present utility, as does the addict, but is ultimately dependent on the firm to provide her with the same opportunities in the future. Applying the theoretical framework we develop to the real world can help explain much of observable behavior and compensation practice. Thus, far from being prima facie evidence of corporate fraud—the picture painted by the media, academia, and prosecutors at recent corporate trials—high levels of in-kind compensation, corporate loans, and personal consumption may be evidence of optimal incentivization, where principal and agent have contracted (explicitly or implicitly) for just the amount and type of remuneration that maximizes their joint welfare.

Number

221

Additional Information

revised 10/04

Included in

Law Commons

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