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Optimal Ratcheting in Executive Compensation

Author

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  • Iny Hwang

    (SNU Business School, Seoul National University, Seoul 08826, Republic of Korea)

  • Youngsoo Kim

    (Culverhouse College of Business, University of Alabama, Tuscaloosa, Alabama 35487)

  • Michael K. Lim

    (SNU Business School, Seoul National University, Seoul 08826, Republic of Korea)

Abstract

Recent empirical studies point out that the firms do not fully incorporate the managers’ past performance when revising future contractual terms. This study offers a theoretical perspective on the firm’s executive compensation strategy that supports such latest empirical findings. Using a two-period principal-agent model, we examine firm’s compensation schemes with ratchet principle taking into account key factors such as informational rent, capability uncertainty, and performance noise. After characterizing the optimal incentive rates for a given degree of ratcheting, we examine the efficacy of ratcheting contract in executive compensation. We also explore the optimal degree of ratcheting that strikes a fine balance between informational rent and ratchet effect. We find that the capability gap-performance noise ratio plays a critical role in determining the optimal degree of ratcheting.

Suggested Citation

  • Iny Hwang & Youngsoo Kim & Michael K. Lim, 2023. "Optimal Ratcheting in Executive Compensation," Decision Analysis, INFORMS, vol. 20(2), pages 166-185, June.
    • Handle: RePEc:inm:ordeca:v:20:y:2023:i:2:p:166-185
    DOI: 10.1287/deca.2023.0467
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    References listed on IDEAS

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