Working Paper: CEPR ID: DP6890
Authors: Jean-Pierre Danthine; John B. Donaldson
Abstract: We reexamine the issue of executive compensation within a general equilibrium production context. Intertemporal optimality places strong restrictions on the form of a representative manager's compensation contract, restrictions that appear to be incompatible with the fact that the bulk of many high-profile managers' compensation is in the form of various options and option-like rewards. We therefore measure the extent to which a convex contract alone can induce the manager to adopt near-optimal investment and hiring decisions. To ask this question is essentially to ask if such contracts can effectively align the stochastic discount factor of the manager with that of the shareholder-workers. We detail exact circumstances under which this alignment is possible and when it is not.
Keywords: business cycles; convex contracts; corporate governance; executive compensation; optimal contracting; stock options
JEL Codes: E32; E44
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| convex compensation contract (D86) | near-optimal investment and hiring decisions (G11) |
| failure to adapt salary component (J33) | passive investment policies (G11) |
| passive investment policies (G11) | macroeconomic inefficiencies (D61) |
| small or smooth salary component (J31) | timid response to investment opportunities (G31) |
| timid response to investment opportunities (G31) | less responsive economy (P19) |
| characteristics of the contract (K12) | impact on macroeconomic dynamics (F41) |
| design of compensation contracts (J33) | optimal economic performance (D61) |