Can Agents Be Better Off with Pay Caps?

22 Pages Posted: 30 Sep 2015

See all articles by Eric S. Chou

Eric S. Chou

National Tsing Hua University

Chien‐Lung Chen

Academia Sinica

Date Written: October 2015

Abstract

A popular way to discipline the managers of companies or banks that got into trouble during the recent financial crisis has been to impose caps on managers' pay. Using a small extension of the standard principal–agent model, we argue that pay caps might serve the opposite purpose, because the agent might be better off with a pay cap. Specifically, we show that, given a fixed effort level to be implemented, the agent's expected utility can be decreasing in an upper bound for the agent's reward. The effect of pay caps on the general structure of optimal incentive contracts is also characterized. While an improvement of contracting information always helps the principal, it might increase or decrease the marginal cost of imposing pay caps.

Keywords: Executive compensation, incentive contracts, limited liability

JEL Classification: D86, J33, M12, M52

Suggested Citation

Chou, Eric S. and Chen, Chien‐Lung, Can Agents Be Better Off with Pay Caps? (October 2015). The Scandinavian Journal of Economics, Vol. 117, Issue 4, pp. 1069-1090, 2015, Available at SSRN: https://ssrn.com/abstract=2667297 or http://dx.doi.org/10.1111/sjoe.12115

Eric S. Chou (Contact Author)

National Tsing Hua University ( email )

No. 101, Section 2, Guangfu Road, East District
Hsin Chu 3, 300
China

Chien‐Lung Chen

Academia Sinica ( email )

Nankang
Taipei, 11529
Taiwan

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