Managerial Expertise, Private Information, and Pay-Performance Sensitivity

43 Pages Posted: 21 Mar 2007

See all articles by Sunil Dutta

Sunil Dutta

University of California, Berkeley - Haas School of Business

Date Written: March 2007

Abstract

This paper characterizes optimal pay-performance sensitivities of compensation contracts for managers who have private information about their skills, and those skills affect their outside employment opportunities. The model presumes that the rate at which a manager's opportunity wage increases in his expertise depends on the nature of that expertise, i.e., whether it is general or firm-specific. The analysis demonstrates that when managerial expertise is largely firm-specific (general), the optimal pay-performance sensitivity is lower (higher) than its optimal value in a benchmark setting of symmetric information. Furthermore, when managerial skills are largely firm-specific (general), the optimal pay-performance sensitivity decreases (increases) as managerial skills become a more important determinant of firm performance. Unlike the standard agency theoretic prediction of a negative trade-off between risk and pay-performance sensitivity, the paper identifies plausible circumstances under which risk and incentives are positively associated. In addition to providing an explanation for why empirical tests of risk-incentive relationships have produced mixed results, the analysis generates insights that can be useful in guiding future empirical research.

Keywords: Executive Compensation, Pay-Performance Sensitivity, Risk, Incentives

JEL Classification: D82, J33, M41, M52

Suggested Citation

Dutta, Sunil, Managerial Expertise, Private Information, and Pay-Performance Sensitivity (March 2007). Available at SSRN: https://ssrn.com/abstract=970328 or http://dx.doi.org/10.2139/ssrn.970328

Sunil Dutta (Contact Author)

University of California, Berkeley - Haas School of Business ( email )

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