Naked Economics by Charles Wheelan

Burger King can either spend a lot of time and money monitoring its employees for theft, or it can provide an incentive for you to do it for them. That little sign by the cash register is an ingenious management tool.
    Principal-agent problems are as much a problem at the top of corporate America as they are at the bottom, in large part because the agents who run America’s large corporations (CEOs and other top executives) are not necessarily the principals who own those companies (the shareholders). I own shares in Starbucks, but I don’t even know the CEO’s name. How can I be sure that he (she?) is acting in my best interest? Indeed, there is ample evidence to suggest that corporate managers are no different from Burger King cashiers—they have some incentives that are not always in the best interest of the firm. They may steal from the cash register figuratively by showering themselves with private jets and country club memberships. Or they may make strategic decisions from which they benefit but shareholders do not. For example, a shocking two-thirds of all corporate mergers do not add value to the merged firms and a third of them leave shareholders worse off. Why would very smart CEOs engage so often in behavior that seems to make little financial sense?
    One partial answer, economists have argued, is that CEOs benefit from mergers even when shareholders are left with losses. A CEO draws a lot of attention to himself by engineering a complex corporate transaction. He is left running a bigger company, which is almost always more prestigious, even if the new entity is less profitable than the merged companies were when they were on their own. Big companies have big offices, big salaries, and big airplanes. On the other hand, some mergers and takeovers make perfect strategic sense. As an uninformed shareholder with a large financial stake in the company, how do I tell the difference? If I don’t even know the name of the CEO of Starbucks, how can I be sure that she (he?) is not spending the bulk of her day chasing attractive secretaries around her office? Hell, this is harder than being a manager at Burger King.
    For a time, clever economists believed that stock options were the answer. They were supposed to be the CEO equivalent of the sign near the cash register asking if you received your receipt. Most American CEOs and other important executives receive a large share of their compensation in the form of stock options. These options enable the recipient to purchase the company’s stock in the future at some predetermined price, say $10. If the company is highly profitable and the stock does well, climbing to say $57, then those stock options are very valuable. (It is good to be able to buy something for $10 when it is selling on the open market for $57.) On the other hand, if the company’s stock falls to $7, the options are worthless. There is no point in buying something for $10 when you can buy it on the open market for $3 less. The point of this compensation scheme is to align the incentives of the CEO with the interests of the shareholders. If the share price goes up, the CEO gets rich—but the shareholders do well, too.
    It turns out that wily CEOs can find ways to abuse the options game (just as cashiers can find new ways to steal from the register). Before the first edition of this book came out, I asked Paul Volcker, former chairman of the Federal Reserve, to give it a read since he had been a professor of mine. Volcker read the book. He liked the book. But he said that I should not have written admiringly about stock options as a tool for aligning the interests of shareholders and management because they are “an instrument of the devil.”
    Paul Volcker was right. I was wrong. The potential problem with options is that executives can do things to goose the firm’s stock in the short run that are bad or disastrous for the company in the long run—after the CEO has sold tens of thousands of options