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Why Do Firms Use Incentives that Have No Incentive Effects?

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  • Paul Oyer

    (Stanford University)

Abstract

Firms often pay individuals for group-level, industry-level, or even economy-wide performance when agency theory suggests these contracts provide minimal incentive and lead to inefficient risk bearing. This paper derives a simple model of why firms might choose to implement stock options, profit sharing, and other pay instruments that reward (or penalize) "luck." The model relies on two key assumptions: 1) adjusting the terms of employment contracts is costly to the firm, and 2) agents' outside opportunities are not constant. I explore how firm-performance-based pay will respond to variation in risk aversion, workers' reservation utility, and the correlation between a firm's performance and that of the economy as a whole. I also discuss how the model fits with widely distributed stock options (especially in risky businesses such as high technology), executive compensation, and profit sharing. The model suggests that, while agency theory has focused on incentive compatibility, the often-overlooked participation constraint can help explain many common compensation schemes.

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 1440.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:1440

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  1. 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..
  2. Eric Rasmusen, 1987. "Moral Hazard in Risk-Averse Teams," RAND Journal of Economics, The RAND Corporation, vol. 18(3), pages 428-435, Autumn.
  3. Hermalin, Benjamin E & Weisbach, Michael S, 1998. "Endogenously Chosen Boards of Directors and Their Monitoring of the CEO," American Economic Review, American Economic Association, vol. 88(1), pages 96-118, March.
  4. 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.
  5. Robert Gibbons & Kevin J. Murphy, 1991. "Relative Performance Evaluation for Chief Executive Officers," NBER Working Papers 2944, National Bureau of Economic Research, Inc.
  6. Barro, Jason R & Barro, Robert J, 1990. "Pay, Performance, and Turnover of Bank CEOs," Journal of Labor Economics, University of Chicago Press, vol. 8(4), pages 448-81, October.
  7. Card, David, 1986. "An Empirical Model of Wage Indexation Provisions in Union Contracts," Journal of Political Economy, University of Chicago Press, vol. 94(3), pages S144-75, June.
  8. Thomas, Jonathan & Worrall, Tim, 1988. "Self-enforcing Wage Contracts," Review of Economic Studies, Wiley Blackwell, vol. 55(4), pages 541-54, October.
  9. Jean-Charles Rochet & Lars A. Stole, 2002. "Nonlinear Pricing with Random Participation," Review of Economic Studies, Oxford University Press, vol. 69(1), pages 277-311.
  10. 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.
  11. Patrick Legros & Steven Matthews, 1993. "Efficient and nearly efficient partnerships," ULB Institutional Repository 2013/7040, ULB -- Universite Libre de Bruxelles.
  12. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March.
  13. repec:fth:prinin:431 is not listed on IDEAS
  14. Bengt Holmstrom, 1981. "Moral Hazard in Teams," Discussion Papers 471, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  15. 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.
  16. Robert Drago & John S. Heywood, 1994. "The Choice of Payment Schemes: Australian Establishment Data," Labor and Demography 9402001, EconWPA, revised 04 Feb 1994.
  17. Milton Harris & Bengt Holmstrom, 1981. "A Theory of Wage Dynamics," Discussion Papers 488, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  18. 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.
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