Incentives, Short-termism & Investment

One of the most fundamental concerns with corporations is that they focus on shortterm
profit rather than investing for the long-term. This is a particular concern in the
21st century, where innovation is particularly critical for competitive success.
Moreover, allegations of short-termism have serious social repercussions. Long-term
investments, such as developing blockbuster drugs, or training workers, typically
benefit stakeholders as well as shareholders, but short-term profit only goes to
shareholders. Short-termism can reduce a firms growth opportunities and give rise to
Incentives shape top managers corporate decisions, including investment decisions.
Poor incentives can worsen corporate short-termism while right incentives can drive
top managers towards long term investments that expand the growth potential of the
firm and increase its market value. Investment decisions are though risky and
frequently fail, which can impact the firms market value negatively. An optimal
incentive system should equally lower the chance of imprudent investment decisions.
Given this background, you task in the coursework is to:
1) Study the principal-agent problem to define the broad issue of incentive system
design in the modern firm;
2) Explain the common solution to the principal-agent problem and the requirements
that an optimal incentive system should ideally fulfil;
3) Carefully distinguish between the level and structure of a managers
compensation pay.
4) Explain how common compensation pay structures may affect CEOs investment
behaviour by referring to the empirical literature; and
5) Put forward an incentive mechanism (pay contract) that minimises short-termism,
encourages investment decisions and discourages imprudent risk taking
behaviour. Attempt to justify your proposal by referring to the literature.

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