Agency theory has often been used by economists to explain executive compensation. Managers and shareholders may have divergent interests and risk profiles according to agency theory. For example, managers view their interest in profits as a bonus, unlike shareholders who view their interest as dividends and capital gains. Faced with competing interests, managers may prefer to avoid risking company assets or resources to protect their jobs. In other words, a failed risk can put managers out of work while shareholders only lose part of their portfolio. Risk-averse managers may prefer to pay themselves excessive salaries rather than take risks that could jeopardize the business or result in loss of livelihood. In contrast, executives may take excessive risks because their own money is not on the line. Given that the average CEO tenure is less than five years, risk-averse executives may emphasize short-term goals to the detriment of the organization's long-term goals. Agency theory uses two mechanisms to influence the behavior of managers. The first is the alignment of interests through incentive contracts designed to reward managers for creating value in the company. Conversely, these contracts only provide salary and benefits if their efforts fail to create value. The second is monitoring management's actions through governance procedures to approve all important decisions and limit conflicts of interest. Principal-Agent Model – This model assumes that managers work to produce value for the company in exchange for tangible and intangible benefits, including financial compensation. Although many aspects of the principal-agent relationship are reflected in employment contracts, monitoring agents are limited to observing...... middle of paper ......escalation and shareholder criticism, the dilemma of the compensation committee is whether to pay higher salaries for top talent that could potentially increase company value or lower salaries for inferior talent that could reduce it.d. Tournament Models – This approach assumes that managers are determined by job level, compensation, and promotion opportunities when competing up the company hierarchy for vacant positions. As executives move up in the organization, the chances of promotion decrease. "At the highest rung of the corporate ladder, the probability of being promoted to CEO is so low that a very high relative pay rate is necessary to maintain an adequate incentive effect for senior executives working just below the CEO level” (p. 25). Thus, high-level executives demand a salary increase as they rise to compensate for the reduced probability of promotion..