Working Paper: CEPR ID: DP10566
Authors: Alex Edmans; Xavier Gabaix
Abstract: This article studies traditional and modern theories of executive compensation, bringing them together under a unifying framework. We analyze assignment models of the level of pay, and static and dynamic moral hazard models of incentives, and compare their predictions to empirical findings. We make two broad points. First, traditional optimal contracting theories find it difficult to explain the data, suggesting that compensation results from 'rent extraction' by CEOs. In contrast, more modern theories that arguably better capture the CEO setting do deliver predictions consistent with observed practices, suggesting that these practices need not be inefficient. Second, seemingly innocuous features of the modeling setup, often made for tractability or convenience, can lead to significant differences in the model's implications and conclusions on the efficiency of observed practices. We close by highlighting apparent inefficiencies in executive compensation and additional directions for future research.
Keywords: contract theory; executive compensation; optimal contracting; principal-agent problem; rent extraction
JEL Codes: D84; G34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| traditional optimal contracting theories (D86) | observed compensation data (J30) |
| CEO rent extraction (M12) | observed compensation practices (J33) |
| modern assignment models (C78) | observed practices (C90) |
| modeling choices (C52) | conclusions about efficiency in compensation practices (J33) |
| CEO pay and firm size (M12) | observed practices (C90) |