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Why Do Firms Use Incentives That Have No Incentive Effects?

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  • Oyer, Paul

    (Stanford U)

Abstract

This paper illustrates why firms might choose to implement stock option plans or other pay instruments that reward ``luck.'' I consider a model where adjusting compensation contracts is costly (or wages are rigid) and where agents' outside opportunities are correlated with their firms' performance. I derive conditions under which firms will pay based on firm performance, even when such pay schemes have little or no effect on agents' on-the-job behavior. I derive implications of the model and discuss how it may help explain the use and recent rise of broad-based stock option plans, profit sharing, and the lack of indexing in executive compensation contracts. The model can also help explain the popularity of such financial instruments as tracking stocks and certain venture capital funds. The model suggests that, while agency theory has focused on incentive compatibility, the often overlooked participation constraint can help explain some common compensation schemes.

Suggested Citation

  • Oyer, Paul, 2001. "Why Do Firms Use Incentives That Have No Incentive Effects?," Research Papers 1686, Stanford University, Graduate School of Business.
    • Handle: RePEc:ecl:stabus:1686
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    Cited by:

    1. Hall, Brian J. & Murphy, Kevin J., 2002. "Stock options for undiversified executives," Journal of Accounting and Economics, Elsevier, vol. 33(1), pages 3-42, February.
    2. Jed Devaro & Fidan Ana Kurtulus, 2010. "An Empirical Analysis of Risk, Incentives and the Delegation of Worker Authority," ILR Review, Cornell University, ILR School, vol. 63(4), pages 641-661, July.
    3. Pierre Chaigneau, 2012. "On the Value of Improved Informativeness," Cahiers de recherche 1205, CIRPEE.
    4. Brian J. Hall & Thomas A. Knox, 2002. "Managing Option Fragility," NBER Working Papers 9059, National Bureau of Economic Research, Inc.
    5. Carter, Mary Ellen & Lynch, Luann J., 2004. "The effect of stock option repricing on employee turnover," Journal of Accounting and Economics, Elsevier, vol. 37(1), pages 91-112, February.
    6. Ruslan Gurtoviy & Luis G. González, 2008. "How Much to Pay in Cash? Employee Retention via Stock Options," Papers on Strategic Interaction 2004-24, Max Planck Institute of Economics, Strategic Interaction Group.
    7. Jenter, Dirk, 2004. "Executive Compensation, Incentives, and Risk," Working papers 4466-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
    8. Matthias Benz & Alois Stutzer, "undated". "Was erklärt die steigenden Managerlöhne? Ein Diskussionsbeitrag," IEW - Working Papers 081, Institute for Empirical Research in Economics - University of Zurich.
    9. Brian J. Hall & Thomas A. Knox, 2004. "Underwater Options and the Dynamics of Executive Pay‐to‐Performance Sensitivities," Journal of Accounting Research, Wiley Blackwell, vol. 42(2), pages 365-412, May.
    10. J. Nellie Liang & Scott Weisbenner, 2001. "Who benefits from a bull market? an analysis of employee stock option grants and stock prices," Finance and Economics Discussion Series 2001-57, Board of Governors of the Federal Reserve System (U.S.).
    11. DeVaro, Jed, 2011. "Using "opposing responses" and relative performance to distinguish empirically among alternative models of promotions," MPRA Paper 35175, University Library of Munich, Germany.
    12. Francine Lafontaine & Scott E. Masten, 2002. "Contracting in the Absence of Specific Investments and Moral Hazard: Understanding Carrier-Driver Relations in U.S. Trucking," NBER Working Papers 8859, National Bureau of Economic Research, Inc.
    13. Kunz, Alexis H. & Pfaff, Dieter, 2002. "Agency theory, performance evaluation, and the hypothetical construct of intrinsic motivation," Accounting, Organizations and Society, Elsevier, vol. 27(3), pages 275-295, April.

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