A Dynamic Model of Managerial Entrenchment and the Positive Incentives It Creates

45 Pages Posted: 5 Nov 2019 Last revised: 8 Dec 2020

See all articles by Graeme Guthrie

Graeme Guthrie

Victoria University of Wellington - Te Herenga Waka - School of Economics & Finance

Date Written: December 8, 2020

Abstract

This paper presents a real-options model of entrenchment in which a CEO chooses how much effort to put into boosting a firm's productivity and the board and CEO bargain over executive-compensation and investment policies. The surplus that bargaining allocates derives from the reduction in value of the firm's capital that occurs if the CEO is replaced. Even if the CEO has no ownership stake, she exerts effort in order to increase the value of the capital at risk. This increases the shared surplus, which increases the CEO's current pay. Newly appointed CEOs are paid less and work harder than their entrenched counterparts. They exert more effort at firms where the CEO's human capital is more important. In contrast, entrenched CEOs exert more effort at firms where their human capital is less important and turnover-induced disruption has a higher cost. Both types work harder when average productivity growth is higher and productivity growth is more sensitive to effort. The board and CEO will agree to accept a degree of investment inefficiency if this allows them to slow down the CEO's entrenchment.

Keywords: corporate governance, entrenchment, executive compensation, Nash bargaining solution, ownership-based incentives

JEL Classification: C78, D25, G34, G35, M12

Suggested Citation

Guthrie, Graeme, A Dynamic Model of Managerial Entrenchment and the Positive Incentives It Creates (December 8, 2020). Available at SSRN: https://ssrn.com/abstract=3475272 or http://dx.doi.org/10.2139/ssrn.3475272

Graeme Guthrie (Contact Author)

Victoria University of Wellington - Te Herenga Waka - School of Economics & Finance ( email )

P.O. Box 600
Wellington 6140
New Zealand

HOME PAGE: http://sites.google.com/view/graemeguthrie

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