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A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium


Alex Edmans


University of Pennsylvania - Finance Department; London Business School - Institute of Finance and Accounting; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Xavier Gabaix


New York University - Stern School of Business; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Augustin Landier


Toulouse School of Economics
June 29, 2011

Review of Financial Studies, Vol. 22, No. 12, pp. 4881-4917, December 2009
EFA 2008 Athens Meetings Paper

Abstract:     
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.

Number of Pages in PDF File: 42

Keywords: Executive compensation, multiplicative preferences, pay-performance sensitivity, incentives, perks, optimal contracting, calibration

JEL Classification: D2, D3, G34, J3

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Date posted: March 19, 2008 ; Last revised: December 7, 2011

Suggested Citation

Edmans, Alex, Gabaix, Xavier and Landier, Augustin, A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium (June 29, 2011). Review of Financial Studies, Vol. 22, No. 12, pp. 4881-4917, December 2009; EFA 2008 Athens Meetings Paper. Available at SSRN: http://ssrn.com/abstract=999096

Contact Information

Alex Edmans (Contact Author)
University of Pennsylvania - Finance Department ( email )
The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States

London Business School - Institute of Finance and Accounting ( email )
Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
European Corporate Governance Institute (ECGI) ( email )
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
Xavier Gabaix
New York University - Stern School of Business ( email )
Stern School of Business
44 West 4th Street, Suite 9-190
New York, NY 10012-1126
United States
HOME PAGE: http://pages.stern.nyu.edu/~xgabaix/
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
European Corporate Governance Institute (ECGI)
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
Augustin Landier
Toulouse School of Economics ( email )
Place Anatole-France
Toulouse Cedex, F-31042
France
Feedback to SSRN (Beta)


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