At the May 26th HEC centennial debate on responsible management, Dr. Schwab formulated an implicit criticism to managerial incentives by asking why managers should benefit from variable compensation (bonuses) and not physicians. Dr. Schwab pointed out that, in contrast to managers, physicians (medical doctors) do not receive a bonus depending on the results of their intervention.
I’d like to try here to answer Dr. Schwab. Indeed, managers and physicians share a common feature: both professions benefit from information asymmetry. According to agency theory (Ross, 1973) and the law, managers are expected to find the appropriate actions to satisfy shareholders (their principals) who delegate on managers because managerial agents are supposed to have the necessary knowledge and information to make adequate decisions that shareholders don’t have. In a similar way, physicians are the “agents” of their customers or patients who ignore how to diagnose and deal with their symptoms of pain or unhealthiness. Physicians are trained to correctly diagnose patients’ health problems and find the appropriate solution. Both shareholders and patients pay their agents – managers and physicians – respectively, for their services.
That said, I think there are two radical differences between these two professions – management and medicine.
First, variable compensation is the device that agency theory (e.g. Ross, 1973) proposes to align the interests of shareholders and managers, because as part of organizational economics, agency theory assumes that individuals are rational and thus self-interested. This means that managers might pursue their interests in spite or even at the expense of their shareholders. Physicians like managers are probably in general equally self-interested, although of course, there might be individual variation. However, in contrast to managers, most physicians across the world (have to) abide by the Hippocratic oath which entails a professional commitment to take care of their patients, to do the best for their “principals’” health and do not harm them. This oath is held as the central or essential value of the profession, defended by professional associations through their ethical committees. Infringing the Hippocratic oath can lead to indictment and thus have legal and reputational consequences.
Therefore, physicians are always expected to “deliver”, i.e. to promptly and correctly diagnose and remedy health problems, if the appropriate cure (i.e. medicines) exists. Mistakes are considered malpractice and, if indicted and proved, legally reprimanded. This is probably because medical knowledge is (considered to be) more advanced and scientific than managerial knowledge. Management research is indeed a more recent scientific interdisciplinary endeavor which started to be carried out systematically in 1950s, with only few earlier precedents such as Taylor (1911) and Barnard (1938). The relative advancement of medicine versus management research and knowledge probably also explains the fact that it is much less clear what good management is than what carrying good medicine entails. Despite some normative knowledge taught in business schools – mostly in quantitative areas like accounting and finance – and/or popularized in practitioner-oriented books, it is less possible to prescribe what a manager facing a particular situation has to do than what a physician ought to do in a particular case. In fact, thanks to education and regulation, the medical world compared to management practice appears to exhibit a much higher degree of formal routinization of what actions – tests, treatments,…- physicians should carry out when facing a particular case. Physicians in both public or private organizations – whether profit or non-profit – are constrained by their management to follow these routines.
Second, managers also face a more complicated task than physicians in a way. Because of their interdependence and complexity (of the many actors which intervene), organizations and their environments are probably more unpredictable and changing than individual health. This is why the law exempts managers from liable responsibility if, despite poor organizational performance, managers exerted fair judgment, i.e. made the decisions they could make with the information they had at their disposal at the time they made their decisions. In this case, managerial decisions and actions are not considered an act of mismanagement or negligence.
The temporal horizon which managers must take into account is also probably more extended than the one which physicians usually take into consideration when evaluating a particular health problem of an individual. This required longer temporal horizon due to investment maturation also explains why variable managerial compensation or bonuses are based on at least a year’s performance or why stock options have a vesting period of at least three years. This is to encourage managerial effort during a longer period to make it compatible with the temporal horizon of investment maturation and thus have managers take a ”long-term” view (and the risks associated with it) rather than short-term “maximization”. One could argue, though, that health decisions today also influence future health.
In any event, there are at least two questions about the usefulness of variable compensation. First, if we believe in the causal ambiguity of managerial actions given the interdependence and uncertainty of firms’ environment, then it seems hard to believe that variable compensation will allow managers to make better decisions. There are two possible interrelated causes of better decisions: knowledge and effort. Incentives might trigger managers to engage in more information search and training, which means greater effort. This, however, assumes that managers are only extrinsically motivated, i.e. they only care about economic remuneration. Agency theory also assumes that effort causes a disutility to the agent, that is, that effort is disagreable for the agent. However, as we know, intrinsic motivation might also exist and some authors have argued and showed that extrinsic rewards might crowd out (reduce) intrinsic motivation (Frey & Oberholzer-Gee, 1997). Second, agency theory assumes that managers are risk-averse. Thus, transferring risk to managers through variable compensation might trigger managerial decisions which actually try to reduce the firm’s risk and thus managers’ remuneration risk (Wiseman & Gomez-Mejia, 1988). In a study of French largest publicly-traded firms, my coauthor and I have found evidence of the link between variable compensation and risk diversification (Castañer & Kavadis, 2011).
In sum, while there are several reasons that may explain why managers and not physicians enjoy variable compensation, it is not clear that variable compensation might actually encourage managers to make better decisions, at least for their shareholders.
Barnard, C. 1938. The functions of the executive. Belknap Press.
Castañer, X. & Kavadis, N. 2011. Does good corporate governance prevent bad diversification? Working paper.
Frey, B. & Oberholzer-Gee, F. 1997. The cost of price incentives: An empirical analysis of motivation crowding-out. American Economic Review, 87: 746-.
Ross S. 1973. The economic theory of agency: The principal’s problem. American Economic Review, 63: 134- 139.
Taylor, F. 1911. The principles of scientific management. Harper Bros, New York.
Wiseman, R. & Gómez-Mejía, L.R. 1998. A behavioral agency model of managerial risk-taking. Academy of Management Review, 23(1): 133-153.