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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. Robert Drago & John S. Heywood, 1994. "The Choice of Payment Schemes: Australian Establishment Data," Labor and Demography 9402001, EconWPA, revised 04 Feb 1994.
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  9. 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..
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  12. Rajesh K. Aggarwal & Andrew A. Samwick, 1999. "Executive Compensation, Strategic Competition, and Relative Performance Evaluation: Theory and Evidence," Journal of Finance, American Finance Association, vol. 54(6), pages 1999-2043, December.
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  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.
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