Hierarchical Contract, Firm Size, and Pay Sensitivity

Abstract:     
We present a moral-hazard-based hierarchical contracting model, where investors contract the top manager and the top manager contracts all middle managers. We compare effects of hierarchical contracting on managerial contract sensitivities with those of a direct contracting benchmark where investors directly contract all managers. We argue that under hierarchical contracting, the top manager shifts his compensation risk to middle managers by providing middle managers with higher-powered incentive contracts than would be desired by investors under direct contracting. It is striking that this top managerial risk-shifting behavior motivates investors to design the top managerial contract in such a way that the top-managerial hierarchical contract sensitivity approaches either the first best or zero, as the firm size grows. However, under some reasonable conditions such as correlated managerial effort outcomes, the top managerial sensitivity quickly approaches zero as the firm size increases, and consequently, the sensitivity for large firms can be far lower than predicted by the standard agency theory. This result can serve as an explanation of widely observed firm-size effects on CEO compensations, namely, lower pay sensitivities for large firms than those for small firms. We also argue that even when investors are risk-neutral and then individual performance outcomes of nonexecutive employees may be very weakly correlated to the total outcome of the firm, company-wide bonus plans for nonexecutive employees can still be justified under hierarchical contracting.

Keywords: hierarchical contract, firm size, pay sensitivity, CEO compensation, middle managerial contract, principal-agent problem, many agents, moral hazard, team, performance measure, continuous-time model

JEL Classification: D86, G30, L14, L22, L25

working papers series