Working Paper: CEPR ID: DP7836
Authors: Alex Edmans; Xavier Gabaix
Abstract: This paper presents a market equilibrium model of CEO assignment, pay and incentives under risk aversion and heterogeneous moral hazard. Each of the three outcomes can be summarized by a single closed-form equation. In assignment models without moral hazard, allocation depends only on firm size and the equilibrium is efficient. Here, talent assignment is distorted by the agency problem as firms involving higher risk or disutility choose less talented CEOs. Such firms also pay higher salaries in the cross-section, but economy-wide increases in risk or the disutility of being a CEO (e.g. due to regulation) do not affect pay. The strength of incentives depends only on the disutility of effort and is independent of risk and risk aversion. If the CEO affects the volatility as well as mean of firm returns, incentives rise and are increasing in risk and risk aversion. We calibrate the efficiency losses from various forms of poor corporate governance, such as failures in monitoring and inefficiencies in CEO assignment. The losses from misallocation of talent are orders of magnitude higher than from inefficient risk-sharing.
Keywords: assignment; executive compensation; incentives; market equilibrium; risk; talent
JEL Codes: D2; D3; G34; J3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher risk or disutility (D81) | Less talented CEOs (D29) |
| Agency problem (G34) | Talent Assignment Distortion (C78) |
| Firm size, risk, and disutility (D21) | Expected level of pay (J31) |
| Misallocation of talent (D29) | Economic inefficiencies (D61) |
| Disutility of effort (D11) | Strength of incentives (M52) |
| Growth of non-corporate sector (O17) | Decrease in overall firm value (G32) |