A Theory of Fair CEO Pay

Abstract

This paper studies optimal executive pay when the CEO has fairness concerns: if his wage falls below a perceived fair share of output, he suffers disutility that is increasing in the discrepancy. Fairness concerns do not lead to fair wages always being paid; instead, the firm threatens the CEO with unfair wages for low output to induce effort. The optimal contract sometimes involves performance shares: the CEO is paid a constant share of output if it is sufficiently high, but the wage drops discontinuously to zero if output falls below a threshold. Even if the incentive constraint is slack, the optimal contract features pay-for-performance, to address the CEO's fairness concerns and ensure his participation. This rationalizes pay-for-performance even if the CEO does not need effort incentives.

Keywords: Executive compensation, fairness, moral hazard

JEL Classification: D86, G32, G34, J33