• Selected
• Entire List

Abstract:
Using a data set containing more than 1,000 observations on CEO succession in large U.S. firms over the period 1974-1995, we examine empirically the choice between insiders and outsiders as CEO. We employ a theoretical framework in which firms value both the incentive that the contest to become CEO provides to insiders and the choice of a more able (whether insider or outsider) CEO. This framework predicts that a firm will be more likely to choose an insider to succeed to the CEO position where commonality among inside candidates is greater, where there are more inside candidates, and where the firm's industry is less homogeneous. Employing a novel measure of insider commonality based upon firm organizational structure and Parrino's (1997) measure of industry homogeneity, logistic regressions provide evidence consistent with each of these predictions and offer useful insight into firms' choice between insiders and outsiders as CEO.

Abstract:
Firms tend to promote insiders to the CEO position rather than to hire outsiders. This paper explains this phenomenon by developing a framework in which firms value the incentive that the contest to become CEO provides to current employees, but also want the most able candidate (insider or outsider) to become CEO. We determine the optimal payment to current employees, the payment to the new CEO if she is promoted from within, the payment to the new CEO if he is hired from outside, and the size of the handicap imposed on outside candidates (i.e., the bias toward insiders). We find that, at the optimum, outsiders must be clearly superior for the firm to facilitate their selection via negative handicapping (i.e., a bias towards outsiders). By contrast, if outsiders are not clearly superior, incentive provision to insiders via handicapping of outsiders or via higher payments to successful insiders is more important than selecting the most able CEO. We also find that the ability (or inability) of a firm to precommit to a large payment to a promoted insider CEO is critical. The ability to precommit reduces the handicap imposed on outsiders, raises the payment to insider CEOs, and lowers the payment to current employees. The outsider handicap, and so the likelihood that an insider will be chosen, depends positively on the number of insiders and the number of outsiders competing to be CEO, provided that the firm cannot precommit. The handicap imposed on outsiders can depend positively on the extent of commonality among insiders, provided that the firm wants to elicit effort from insiders but this effort is relatively small. The handicap depends negatively on the average ability of outsiders, the extent of commonality among insiders (provided that the firm wants to elicit effort from insiders and this effort is relatively large), the similarity of the shocks faced by insiders and outsiders, and financial stress faced by the firm.

Contests, CEO contracts, tournaments, moral hazard

Abstract:
We argue that outsiders are handicapped in CEO successions to strengthen the incentive that the contest to become CEO provides inside candidates. Handicapping implies that a firm is more likely to pick an insider for the CEO position where insiders are more comparable to each other and less comparable to outsiders, and where there are more inside candidates. Using a novel measure of the comparability of insiders based on firm organizational structure, we analyze over 1,000 CEO successions in large U.S. firms over the 1974-1995 period and find a variety of evidence consistent with these implications of handicapping.

CEO succession, Corporate governance, Promotion incentives, Executive compensation, Tournament theory

Abstract:
Should a firm favor insiders (handicap outsiders) when selecting a CEO? One reason to do so is to take advantage of the contest to become CEO as a device for providing current incentives to employees. An important reason not to do so is that this can reduce the ability of future CEOs and, hence, future profits. The trade-off between providing current incentives and selecting the most able individual to become CEO is the focus of this paper. If insiders are good enough (better or nearly as good as outsiders), incentive provision to insiders typically dominates and it is optimal to handicap outsiders, sometimes so severely that they have no chance to win the contest. However, if outsiders are sufficiently better than insiders, selection dominates and it is the insiders who are severely handicapped. This finding is in sharp contrast to the existing literature which has so far ignored this trade-off. In all, our model provides useful insight into contests to become CEO and rationalizes empirical regularities in the source of CEOs chosen by firms. In particular, our analysis helps to explain the lower tendency of firms in more heterogeneous industries and firms with a product or line of business organizational structure to select an outsider as CEO.

Contests, CEO contracts, moral hazard

Abstract:
Grower discontent with tournaments as mechanisms for settling poultry contracts can largely be attributed to the group composition risk that tournaments impose on growers. This paper focuses on the welfare effects of a widely advocated regulatory proposal to prevent integrator companies from using tournaments and replace them with schemes that compare performance to a fixed standard. The analysis shows that the mandatory replacement of tournaments with fixed performance standards, absent any rules that regulate the magnitude of the piece rate, will decrease grower income insurance without raising welfare. However, replacing tournaments with fixed performance standards can simultaneously increase income insurance and welfare, provided that the magnitude of the piece rate is also regulated.

Abstract:
Current literature has largely ignored the fact that some organizations are highly selective when admitting new agents while others are more open. In addition, some organizations audit or sort agent behavior within the organization more aggressively than others. One might expect a priori that closed, highly selective, organizations would always be more efficient because they screen out the worst types, which could lead to better agent behavior. We show that this is not the case. Specifically, when agent behavior in equilibrium is uniform across organizations (i.e., when the number of agents behaving the same way is identical), closed organizations are inefficient. However, when agent behavior varies across organizations, closed organizations may or may not be inefficient, depending on net payoffs to the organization and the agents. Our analysis implies that organizations should choose the open type when screening or sorting costs are high, when there is a high frequency of good agent types in the population, when agent misbehavior does not reduce output significantly, and when penalties for misbehavior
are large.

Asymmetric information, organization theory, efficiency, sorting, screening

Abstract:
A highly acclaimed result in contract theory is that tournaments are superior to piece rate contracts when the agents are risk averse and their production activities are subject to a relatively large common shock. The reason is that tournaments allow the principal to trade insurance for lower income to the agents. Our analysis shows that this celebrated result does not carry over to the case when a limited liability constraint limits the payments the principal can make, provided that the liquidation value of the firm is sufficiently small. This finding has important implications for the vast number of limited liability firms. Tournaments are still optimal when the liquidation value of the firm is intermediate or large, even though the limited liability constraint is still binding for intermediate values. Surprisingly, uncertainty in the price of output strengthens the need for tournaments by expanding the range of liquidation values over which tournaments are optimal, because price uncertainty introduces additional bankruptcy risk.

piece rate contracts, tournaments, limited liability, bankruptcy, price uncertainty

Abstract:
This paper compares relative performance evaluation via tournaments to absolute performance evaluation via piece rates when agents are heterogeneous ex post, to make the point that agent heterogeneity compromises the insurance function of tournaments. In particular, we show that the more heterogeneous agents are the less insurance can be offered through tournaments and the less dominant tournaments are over piece rates. Thus, absolute performance piece rates should be preferred when agents are highly heterogeneous. However, even with heterogeneous agents, tournaments become more desirable when the number of agents or the uncertainty about the common shock increases sufficiently.

Piece rates, Tournaments

Abstract:
A celebrated result in the theory of tournaments is that relative performance evaluation (tournaments) is a superior compensation method to absolute performance evaluation (piece rate contracts) when the agents are risk-averse, the principal is risk-neutral or less risk-averse than the agents and production is subject to common shocks that are large relative to the idiosyncratic shocks. This is because tournaments get closer to the first best by filtering common uncertainty. This paper shows that, surprisingly, tournaments are superior even when agents are liquidity constrained so that transfers to them cannot fall short of a predetermined level. The rationale is that, by providing insurance against common shocks through a tournament, payments to the agents in unfavorable states increase and payments in favorable states decrease which enables the principal to satisfy tight liquidity constraints for the agents without paying any ex ante rents to them, while simultaneously providing higher-power incentives than under piece rates.

Piece rates, tournaments, liquidity constraints

Abstract:
We examine the strategic role of information transmission in a repeated principal-agent relationship where the agent produces information that is useful to the principal. The agent values continuous employment for the principal because he makes a relationship-specific investment that can yield rents to him when the relationship is renewed. Assuming that the parties are sufficiently impatient, we show that full disclosure of the information produced occurs early in the relationship when the principal can commit to a long-term relationship, when the agent observes his valuation of continuous employment after making a report on information produced, or when the agent obtains a low valuation of continuous employment before making a report. By contrast, a strategic delay in the transmission of information occurs when the principal can only commit to a short-term relationship and the agent obtains a high valuation of continuous employment before making a report.