Optimal CEO Incentives and Industry Dynamics

67 Pages Posted: 8 Jan 2013

See all articles by Antonio Falato

Antonio Falato

Board of Governors of the Federal Reserve System

Dalida Kadyrzhanova

Georgia State University

Date Written: October 1, 2012

Abstract

This paper develops a competitive equilibrium model of CEO compensation and industry dynamics. CEOs make product pricing and product improvement decisions subject to shareholders' compensation choices and idiosyncratic shocks to product quality. The choice of high-powered incentives optimally trades off the benefits from expected product improvements and the associated agency costs. In market equilibrium, the interaction between CEO pay and product market decisions affects the stationary distribution of firms. We characterize a dynamic feedback effect of industry structure on CEO incentives. As a result of this effect, we predict that the performance-based component of CEO pay should be higher, (i) across industries, when the degree of heterogeneity of industry structure is lower; (ii) within industries, when firms are laggards with respect to their industry peers. We empirically estimate pay-performance sensitivity for a large sample of U.S. CEOs and other top executives over the 1993 to 2004 period and find strong support for our theory. Our results offer a novel product market rationale for the increased reliance of CEO pay on bonuses and stock options over the 1990s.

Keywords: CEO compensation, product market structure

JEL Classification: G3

Suggested Citation

Falato, Antonio and Kadyrzhanova, Dalida, Optimal CEO Incentives and Industry Dynamics (October 1, 2012). FEDS Working Paper No. 2012-78. Available at SSRN: https://ssrn.com/abstract=2197495 or http://dx.doi.org/10.2139/ssrn.2197495

Antonio Falato (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th & C. St., N.W.
Washington, DC 20551
United States

Dalida Kadyrzhanova

Georgia State University ( email )

J Mack Robinson College of Business
35 Broad St, 12th Floor
Atlanta, GA 30303-3083
United States

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