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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.

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Bibliographic Info

Paper provided by Stanford University, Graduate School of Business in its series Research Papers with number 1686.

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Date of creation: Apr 2001
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Handle: RePEc:ecl:stabus:1686

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  1. Harris, Milton & Holstrom, Bengt, 1982. "A Theory of Wage Dynamics," Review of Economic Studies, Wiley Blackwell, vol. 49(3), pages 315-33, July.
  2. Bengt Holmstrom, 1982. "Moral Hazard in Teams," Bell Journal of Economics, The RAND Corporation, vol. 13(2), pages 324-340, Autumn.
  3. Gibbons, R. & Murphy, K.J., 1989. "Relative Performance Evaluation For Chief Executive Officers," Working papers 532, Massachusetts Institute of Technology (MIT), Department of Economics.
  4. repec:fth:prinin:431 is not listed on IDEAS
  5. Rochet, Jean-Charles & Stole, Lars A, 2002. "Nonlinear Pricing with Random Participation," Review of Economic Studies, Wiley Blackwell, vol. 69(1), pages 277-311, January.
  6. Robert W Drago & John S. Heywood, 1995. "The Choice of Payment Schemes: Australian Establishment Data," Working papers _006, University of Wisconsin - Milwaukee.
  7. Beaudry, Paul & DiNardo, John, 1991. "The Effect of Implicit Contracts on the Movement of Wages over the Business Cycle: Evidence from Micro Data," Journal of Political Economy, University of Chicago Press, vol. 99(4), pages 665-88, August.
  8. Barro, Jason R. & Barro, Robert J., 1990. "Pay, Performance, and Turnover of Bank CEOs," Scholarly Articles 3451300, Harvard University Department of Economics.
  9. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March.
  10. Benjamin E. Hermalin & Michael S. Weisbach, 1996. "Endogenously Chosen Boards of Directors and Their Monitoring of the CEO," Working Papers _004, University of California at Berkeley, Haas School of Business.
  11. Eric Rasmusen, 1987. "Moral Hazard in Risk-Averse Teams," RAND Journal of Economics, The RAND Corporation, vol. 18(3), pages 428-435, Autumn.
  12. Rajesh Aggarwal & Andrew A. Samwick, 1996. "Executive Compensation, Strategic Competition, and Relative Performance Evaluation: Theory and Evidence," NBER Working Papers 5648, National Bureau of Economic Research, Inc.
  13. David Card, 1984. "An Empirical Model of Wage Indexation Provisions in Union Contracts," NBER Working Papers 1388, National Bureau of Economic Research, Inc.
  14. Alston, Lee J. & Higgs, Robert, 1982. "Contractual Mix in Southern Agriculture since the Civil War: Facts, Hypotheses, and Tests," The Journal of Economic History, Cambridge University Press, vol. 42(02), pages 327-353, June.
  15. Legros, Patrick & Matthews, Steven A, 1993. "Efficient and Nearly-Efficient Partnerships," Review of Economic Studies, Wiley Blackwell, vol. 60(3), pages 599-611, July.
  16. Marianne Bertrand & Sendhil Mullainathan, 2000. "Do CEOs Set Their Own Pay? The Ones Without Principals Do," NBER Working Papers 7604, National Bureau of Economic Research, Inc.
  17. Marianne Bertrand & Sendhil Mullainathan, 2000. "Do CEOs Set Their Own Pay? The Ones Without Principals Do," Working Papers 810, Princeton University, Department of Economics, Industrial Relations Section..
  18. Thomas, Jonathan & Worrall, Tim, 1988. "Self-enforcing Wage Contracts," Review of Economic Studies, Wiley Blackwell, vol. 55(4), pages 541-54, October.
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