Search for Optimal CEO Compensation: Theory and Empirical Evidence

44 Pages Posted: 21 Mar 2007 Last revised: 14 Nov 2013

See all articles by Melanie Cao

Melanie Cao

York University - Schulich School of Business

Rong Wang

Singapore Management University; Singapore Management University - Lee Kong Chian School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: March 18, 2008

Abstract

Much of the agency literature focuses on effort-inducing while little attention is paid to the participation constraint. Intuitively, it is important to jointly address both for CEOs. This paper achieves this by developing a dynamic search equilibrium model which allows for quitting if a CEO is not satisfied with the incentive contract. The reservation utility is endogenized in equilibrium since the value of the CEO's outside option depends on other firms' contracts. As a result, the equilibrium incentive contract exhibits some new and important features which can explain two long-standing puzzles related to the executive compensation practice. First, the equilibrium pay-to-performance-sensitivity negatively depends on the expected aggregate state and a firm's systematic risk, and positively on the firm's specific risk. The separate effects of firms' systematic and specific risks enable us to reconcile the mixed evidence on the relationship between pay-to-performance sensitivity and a firm's risk. Second, the equilibrium salary and total pay depend on the firm's size, which, in turn, increases with the expected aggregate state. This result provides a plausible explanation to the steadily increased compensation paid to executives in the past three decades. These theoretical predictions are broadly supported by our empirical results. Hence, we conclude that the participation constraint is an important determinant for the executive compensation policy.

Keywords: Principal-agent Problem, CEOs' Job Search, Endogenous Reservation Utility, Dynamic Equilibrium, Optimal Compensation Policy

JEL Classification: J33, G13

Suggested Citation

Cao, Melanie and Wang, Rong, Search for Optimal CEO Compensation: Theory and Empirical Evidence (March 18, 2008). AFA 2009 San Francisco Meetings Paper, Available at SSRN: https://ssrn.com/abstract=972118 or http://dx.doi.org/10.2139/ssrn.972118

Melanie Cao (Contact Author)

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
416-736-2100 ext. 33801 (Phone)

Rong Wang

Singapore Management University ( email )

Li Ka Shing Library
70 Stamford Road
Singapore 178901, 178899
Singapore

Singapore Management University - Lee Kong Chian School of Business ( email )

469 Bukit Timah Road
Singapore 912409
Singapore

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
432
Abstract Views
1,885
rank
54,208
PlumX Metrics