Compensation and Risk: A Perspective on the Lake Wobegon Effect

Abstract

We investigate an alternative economic channel of a positive relationship between risk and compensation, as documented by Cheng, Hong, and Scheinkman (2015). We propose that when information asymmetry exists, firms generally seek to use compensation as a signal of their CEOs’ ability. The risks arising from information asymmetry tend to encourage firms to pay higher compensation to their CEOs in a pattern of financial incentives we call the “Lake Wobegon effect”. However, when individual firms pursue complete signaling, a higher equilibrium compensation level can be achieved. This paper explores the factors that give rise to the “Lake Wobegon effect” and the learning process by which this effect can be counterbalanced over time(Hayes and Schaefer 2009).

Keywords: Compensation, Risk, Asymmetric Information, Learning, Belief

JEL Classification: D83, G44, J33