Working Paper: CEPR ID: DP9000
Authors: Emre Ozdenoren; Kathy Yuan
Abstract: We propose a new theory of suboptimal risk-taking based on contractual externalities. We examine an industry with a continuum of firms. Each firm's manager exerts costly hidden effort The productivity of e ffort is subject to systematic shocks. Firms' stock prices reflect their performance relative to the industry average. In this setting, stock-based incentives cause complementarities in managerial effort choices. Externalities arise because shareholders do not internalize the impact of their incentive provision on the average effort. During booms, they over-incentivise managers, triggering a rat-race in effort exertion, resulting in excessive risk relative to the second-best. The opposite occurs during busts.
Keywords: contractual externalities; excessive risk-taking; insufficient risk-taking; stock-based incentives
JEL Codes: D86; G01; G30
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| high average productivity (O49) | increased stock-based incentives (M52) |
| increased stock-based incentives (M52) | excessive risk-taking (G41) |
| low average productivity (O49) | decreased stock-based incentives (M52) |
| decreased stock-based incentives (M52) | insufficient risk-taking (D81) |