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Performance Thresholds in Managerial Incentive Contracts

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Author Info

  • Xianming Zhou

    (University of Hong Kong)

  • Peter L. Swan

    (University of New South Wales)

Abstract

Performance thresholds are commonly used in executive compensation contracts. We examine the contractual nonlinearity associated with performance thresholds and its incentive implications. Incorporating a performance threshold into a standard principal-agent model of a linear contract, we show that pay schemes using a performance threshold are optimal. By truncating a linear scheme at poor performance, the threshold mitigates agency costs associated with the downside risk of production. Examining CEO compensation data, we find evidence of the role of performance thresholds. As a consequence of under-threshold performance, the tobit estimator is shown to increase pay-performance sensitivity, notably improving upon the standard OLS estimator.

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Bibliographic Info

Article provided by University of Chicago Press in its journal Journal of Business.

Volume (Year): 76 (2003)
Issue (Month): 4 (October)
Pages: 665-696

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Handle: RePEc:ucp:jnlbus:v:76:y:2003:i:4:p:665-696

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Web page: http://www.journals.uchicago.edu/JB/

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Cited by:
  1. Orana Bandiera & Iwan Barankay & Imran Rasul, 2006. "Incentives for managers and inequality among workers: Evidence from a firm level experiment," Natural Field Experiments 00213, The Field Experiments Website.
  2. Gutiérrez Arnaiz, Óscar & Salas-Fumás, Vicente, 2008. "Performance standards and optimal incentives," Journal of Accounting and Economics, Elsevier, vol. 45(1), pages 139-152, March.
  3. Hu, Yifan & Zhou, Xianming, 2008. "The performance effect of managerial ownership: Evidence from China," Journal of Banking & Finance, Elsevier, vol. 32(10), pages 2099-2110, October.

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