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Dynamic Managerial Compensation: a Mechanism Design Approach

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  • Daniel Garrett
  • Alessandro Pavan

Abstract

We characterize the optimal incentive scheme for a manager who faces costly effort decisions and whose ability to generate profits for the firm varies stochastically over time. The optimal contract is obtained as the solution to a dynamic mechanism design problem with hidden actions and persistent shocks to the agent's productivity. When the agent is risk-neutral, the optimal contract can often be implemented with a simple pay package that is linear in the firm's profits. Furthermore, the power of the incentive scheme typically increases over time, thus providing a possible justification for the frequent practice of putting more stocks and options in the package of managers with a longer tenure in the firm. In contrast to other explanations proposed in the literature (e.g., declining disutility of effort or career concerns), the optimality of seniority-based reward schemes is not driven by variations in the agent's preferences or in his outside option. It results from an optimal allocation of the manager's informational rents over time. Building on the insights from the risk-neutral case, we then explore the properties of optimal incentive schemes for risk-averse managers. We find that, other things equal, risk-aversion reduces the benefit of inducing higher effort over time. Whether (risk-averse) managers with a longer tenure receive more or less high-powered incentives than younger ones then depends on the interaction between the degree of risk aversion and the dynamics of the impulse responses for the shocks to the manager's type.

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Bibliographic Info

Paper provided by Collegio Carlo Alberto in its series Carlo Alberto Notebooks with number 127.

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Length: 63 pages
Date of creation: 2009
Date of revision:
Handle: RePEc:cca:wpaper:127

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Keywords: dynamic mechanism design; adverse selection; moral hazard; incentives; optimal pay scheme; risk-aversion; stochastic process;

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References

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  1. Albanesi, Stefania & Sleet, Christopher, 2003. "Dynamic Optimal Taxation with Private Information," CEPR Discussion Papers 4006, C.E.P.R. Discussion Papers.
  2. Marco Battaglini, 2005. "Long-Term Contracting with Markovian Consumers," American Economic Review, American Economic Association, vol. 95(3), pages 637-658, June.
  3. Peter M. DeMarzo & Michael J. Fishman, 2007. "Optimal Long-Term Financial Contracting," Review of Financial Studies, Society for Financial Studies, vol. 20(6), pages 2079-2128, November.
  4. Murphy, K.J. & Gibbons, R., 1990. "Optimal Incentive Contracts in the Presence of Career Concerns : Theory and Evidence," Papers, Rochester, Business - Managerial Economics Research Center 90-09, Rochester, Business - Managerial Economics Research Center.
  5. Mathias Dewatripont & Ian Jewitt & Jean Tirole, 1999. "The economics of career concerns: part 1 :comparing information structures," ULB Institutional Repository 2013/9617, ULB -- Universite Libre de Bruxelles.
  6. Phelan, Christopher & Townsend, Robert M, 1991. "Computing Multi-period, Information-Constrained Optima," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 58(5), pages 853-81, October.
  7. Zhang, Yuzhe, 2009. "Dynamic Contracting with Persistent Shocks," MPRA Paper 23108, University Library of Munich, Germany.
  8. Alessandro Pavan & Ilya Segal & Juuso Toikka, 2009. "Dynamic Mechanism Design: Incentive Compatibility, Profit Maximization and Information Disclosure," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 1501, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  9. Milgrom, Paul & Shannon, Chris, 1994. "Monotone Comparative Statics," Econometrica, Econometric Society, Econometric Society, vol. 62(1), pages 157-80, January.
  10. Battaglini, Marco & Coate, Stephen, 2008. "Pareto efficient income taxation with stochastic abilities," Journal of Public Economics, Elsevier, vol. 92(3-4), pages 844-868, April.
  11. PETER M. DeMARZO & YULIY SANNIKOV, 2006. "Optimal Security Design and Dynamic Capital Structure in a Continuous-Time Agency Model," Journal of Finance, American Finance Association, vol. 61(6), pages 2681-2724, December.
  12. Spear, Stephen E & Srivastava, Sanjay, 1987. "On Repeated Moral Hazard with Discounting," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 54(4), pages 599-617, October.
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Cited by:
  1. Yuliy Sannikov & Xavier Gabaix & Tomasz Sadzik & Alex Edmans, 2010. "Dynamic Incentive Accounts," 2010 Meeting Papers 1207, Society for Economic Dynamics.
  2. Marco LiCalzi & Alessandro Pavan, 2003. "Tilting the Supply Schedule to Enhance Competition in Uniform-Price Auctions," Working Papers 2003.22, Fondazione Eni Enrico Mattei.
  3. George-Marios Angeletos & Alessandro Pavan, 2007. "Socially Optimal Coordination: Characterization and Policy Implications," Journal of the European Economic Association, MIT Press, MIT Press, vol. 5(2-3), pages 585-593, 04-05.
  4. Daniel F. Garrett & Alessandro Pavan, 2012. "Managerial Turnover in a Changing World," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 120(5), pages 879 - 925.

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