A Calibratable Model of Optimal CEO Incentives in Market Equilibrium

50 Pages Posted: 3 Nov 2008

See all articles by Alex Edmans

Alex Edmans

London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Xavier Gabaix

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Augustin Landier

HEC

Multiple version iconThere are 2 versions of this paper

Date Written: November 2007

Abstract

This paper presents a united framework for understanding the determinants of both CEOincentives and total pay levels in competitive market equilibrium. It embeds a modified principal-agent problem into a talent assignment model to endogenize both elements of compensation. The model s closed form solutions yield testable predictions for how incentives should vary across arms under optimal contracting. In particular, our calibrations show that the negative relationship between the CEO s executive equity stake and arm size is quantitatively consistent with e¢ ciency and need not re ect rent extraction. Ourmodel and data both also imply that the dollar change in wealth for a percentage change in arm value, scaled by annual pay, is independent of arm size. This may render it an attractive incentive measure as it is comparable between arms and over time. The theory also predicts a positive relationship between pay volatility and rm volatility, and that risk and effort affect total pay along the cross-section but not in the aggregate. Finally, we demonstrate that incentive compensation is executive at solving large agency problems, such as selecting corporate strategy, but smaller issues such as perk consumption are best addressed through direct monitoring.

Suggested Citation

Edmans, Alex and Gabaix, Xavier and Landier, Augustin, A Calibratable Model of Optimal CEO Incentives in Market Equilibrium (November 2007). NYU Working Paper No. FIN-07-022. Available at SSRN: https://ssrn.com/abstract=1293609

Alex Edmans (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
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Belgium

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Xavier Gabaix

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Augustin Landier

HEC ( email )

France
+33630006051 (Phone)

HOME PAGE: http://https://sites.google.com/site/augustinlandier/

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