Optimal CEO Compensation with Search: Theory and Empirical Evidence
71 Pages Posted: 5 Dec 2012
Date Written: November 12, 2012
We integrate an agency problem into search theory to study executive compensation in a market equilibrium. A CEO can choose to stay or quit and search after privately observing an idiosyncratic shock to the firm. The market equilibrium endogenizes CEOs’ and firms’ outside options and captures contracting externalities. We show that the optimal pay-to-performance ratio is less than one even when the CEO is risk neutral. Moreover, the equilibrium pay-toperformance sensitivity depends positively on a firm’s idiosyncratic risk, and negatively on the systematic risk. Our empirical tests using executive compensation data confirm these results.
Keywords: executive compensation, principal-agent problem, search, endogenous outside options, dynamic market equilibriunm
JEL Classification: J33, G13.
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