Executive Pay, Talent and Firm Size

Abstract

We present an integrated agency model of career concerns and labor market equilibrium. Unlike the existing literature, our managerial reservation utility levels and thus pay levels are endogenously determined, and managers with higher expected talent levels are not necessarily hired by large firms. A number of our theoretical results are supported by our empirical analysis utilizing our multi-period career-concerns model. We find that that CEOs employed by large firms have higher talent levels and are recruited from "tighter" talent distributions. We show that CEOs employed in larger firms are more productive due to scale economies in effort and more notably in talent. Talent is rewarded via both higher pay and CEO income from shareholdings. The model very accurately predicts firm performance and out of sample and also CEO pay levels. Finally, a sizeable portion of the increased real CEO pay levels over recent decades is explicable as compensation for sizeable increases in assets under management as well as for much higher risk.

Keywords: executive pay, firm size, career concern, CEO talent, principal-agent, optimal contract

JEL Classification: G34, J41, J44, L25