A Simple Explanation of the Relative Performance Evaluation Puzzle
AbstractWe study a simple moral hazard model in which two risk-neutral owners establish incentives for their risk-averse managers to exert effort. Because the probability distributions over output realizations depend on a common aggregate shock, optimal contracts make the compensation of each manager contingent on own performance but also on a performance benchmark--the performance of the other firm. If the marginal return of effort depends on the aggregate state, optimal contracts are not monotonically decreasing in the performance benchmark. This provides a simple explanation of the Relative Performance Evaluation (RPE) Puzzle--the documented lack of a negative relationship between CEO compensation and comparative performance measures, such as industry or market performance. Our simple model can also explain one-sided RPE--the documented tendency to insulate a CEO's rewards from bad luck, but not from good luck. We clarify that our results are robust in several dimensions and we discuss other applications of our findings. (Copyright: Elsevier)
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Bibliographic InfoArticle provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.
Volume (Year): 9 (2006)
Issue (Month): 3 (July)
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Find related papers by JEL classification:
- C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- M52 - Business Administration and Business Economics; Marketing; Accounting - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects
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