Working Paper: NBER ID: w13372
Authors: Alex Edmans; Xavier Gabaix; Augustin Landier
Abstract: This paper presents a unified framework for understanding the determinants of both CEO incentives and total pay levels in competitive market equilibrium. It embeds a modified principal-agent problem into a talent assignment model to endogenize both elements of compensation. The model's closed form solutions yield testable predictions for how incentives should vary across firms under optimal contracting. In particular, our calibrations show that the negative relationship between the CEO's effective equity stake and firm size is quantitatively consistent with efficiency and need not reflect rent extraction. Our model and data both also imply that the dollar change in wealth for a percentage change in firm value, scaled by annual pay, is independent of firm size. This may render it an attractive incentive measure as it is comparable between firms and over time. The theory also predicts a positive relationship between pay volatility and firm volatility, and that risk and effort affect total pay along the cross-section but not in the aggregate. Finally, we demonstrate that incentive compensation is effective at solving large agency problems, such as selecting corporate strategy, but smaller issues such as perk consumption are best addressed through direct monitoring.
Keywords: CEO incentives; market equilibrium; agency problems; compensation structures; performance sensitivity
JEL Codes: D2; D3; G34; J3; J41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| incentive compensation (M52) | agency problems (G34) |
| private benefits from actions (H49) | CEO's annual wage (M12) |
| dollar change in wealth for a percentage change in firm value (G32) | firm size (L25) |
| CEO equity stake (M12) | firm size (L25) |
| pay volatility (G13) | firm volatility (G32) |