Sorting Effects of Performance Pay

47 Pages Posted: 29 Jul 2011 Last revised: 22 Feb 2012

Multiple version iconThere are 2 versions of this paper

Date Written: July 25, 2011


Compensation not only provides incentives to existing managers but attracts new managers to the firm. This paper examines the dual incentive and sorting effects of performance pay in a simple contracting model of endogenous participation. The main result is that sorting dampens optimal pay-performance sensitivity (PPS). This occurs because PPS beyond a nominal amount transfers unnecessary rent from the firm to the manager. The result helps explain why empirical estimates of PPS are much lower than predictions from models of moral hazard alone. Finally, the model delivers a number of comparative statics that can be tested against data, predicting a web of relationship between PPS, the quality of the manager, the variation between managers, and the manager's risk aversion and outside option.

Suggested Citation

Ray, Korok, Sorting Effects of Performance Pay (July 25, 2011). Available at SSRN: or

Korok Ray (Contact Author)

Texas A&M University ( email )

4113 TAMU College State
TX 77843-4113
United States


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