Risk and the CEO Market: Why Do Some Large Firms Hire Highly-Paid, Low-Talent CEOS?

43 Pages Posted: 17 May 2010 Last revised: 8 Sep 2010

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)

Multiple version iconThere are 3 versions of this paper

Date Written: May 2010

Abstract

This paper presents a market equilibrium model of CEO assignment, pay and incentives under risk aversion and heterogeneous moral hazard. Each of the three outcomes can be summarized by a single closed-form equation. In assignment models without moral hazard, allocation depends only on firm size and the equilibrium is efficient. Here, talent assignment is distorted by the agency problem as firms involving higher risk or disutility choose less talented CEOs. Such firms also pay higher salaries in the cross-section, but economy-wide increases in risk or the disutility of being a CEO (e.g. due to regulation) do not affect pay. The strength of incentives depends only on the disutility of effort and is independent of risk and risk aversion. If the CEO affects the volatility as well as mean of firm returns, incentives rise and are increasing in risk and risk aversion. We calibrate the efficiency losses from various forms of poor corporate governance, such as failures in monitoring and inefficiencies in CEO assignment. The losses from misallocation of talent are orders of magnitude higher than from inefficient risk-sharing.

Suggested Citation

Edmans, Alex and Gabaix, Xavier, Risk and the CEO Market: Why Do Some Large Firms Hire Highly-Paid, Low-Talent CEOS? (May 2010). NBER Working Paper No. w15987. Available at SSRN: https://ssrn.com/abstract=1607477

Alex Edmans (Contact Author)

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

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London NW1 4SA
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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

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