A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium
University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)
New York University - Stern School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)
Toulouse School of Economics
The Review of Financial Studies, Vol. 22, Issue 12, pp. 4881-4917, 2009
This paper presents a unified theory of both the level and sensitivity of pay in competitive market equilibrium, by embedding a moral hazard problem into a talent assignment model. By considering multiplicative specifications for the CEO's utility and production functions, we generate a number of different results from traditional additive models. First, both the CEO's low fractional ownership (the Jensen-Murphy incentives measure) and its negative relationship with firm size can be quantitatively reconciled with optimal contracting, and thus need not reflect rent extraction. Second, the dollar change in wealth for a percentage change in firm value, divided by annual pay, is independent of firm size, and therefore a desirable empirical measure of incentives. Third, incentive pay is effective at solving agency problems with multiplicative impacts on firm value, such as strategy choice. However, additive issues such as perk consumption are best addressed through direct monitoring.
Keywords: D2, D3, G34, J3Accepted Paper Series
Date posted: November 24, 2009
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