Aversion to the variability of pay and optimal incentive contracts
AbstractIn a moral hazard setting with a performance additive in effort and a symmetrically distributed noise term, I show that compensation contracts which are convex in performance are suboptimal when the agent has mean-variance preferences. With step contracts, I show that sticks are more efficient than carrots: an exogenously given lower bound on payments is binding at the optimum. Intuitively, the variance of the agent's pay conditional on a high effort should be as low as possible, while it should be as high as possible conditional on a low effort. From an ex ante perspective, which is relevant for effort inducement, this maximizes the rewards associated to high effort, and the punishments associated to low effort. These results call into question the widespread use of stock-options and contracts with rewards-like features to provide incentives to risk averse executives.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Financial Markets Group in its series FMG Discussion Papers with number dp654.
Date of creation: Jul 2010
Date of revision:
Contact details of provider:
Web page: http://www.lse.ac.uk/fmg/
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-90, September.
- Medoff, James L & Abraham, Katharine G, 1980.
"Experience, Performance, and Earnings,"
The Quarterly Journal of Economics,
MIT Press, vol. 95(4), pages 703-36, December.
- Brian J. Hall & Jeffrey B. Liebman, 1998.
"Are CEOs Really Paid Like Bureaucrats?,"
The Quarterly Journal of Economics,
MIT Press, vol. 113(3), pages 653-691, August.
- Carola Frydman & Raven E. Saks, 2010.
"Executive Compensation: A New View from a Long-Term Perspective, 1936--2005,"
Review of Financial Studies,
Society for Financial Studies, vol. 23(5), pages 2099-2138.
- Carola Frydman & Raven E. Saks, 2008. "Executive Compensation: A New View from a Long-Term Perspective, 1936-2005," NBER Working Papers 14145, National Bureau of Economic Research, Inc.
- Carola Frydman & Raven E. Saks, 2007. "Executive compensation: a new view from a long-term perspective, 1936-2005," Finance and Economics Discussion Series 2007-35, Board of Governors of the Federal Reserve System (U.S.).
- Murphy, Kevin J., 1999. "Executive compensation," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 38, pages 2485-2563 Elsevier.
- Maug, Ernst & Dittmann, Ingolf, 2007. "Lower Salaries and No Options: The Optimal Structure of Executive Pay," Sonderforschungsbereich 504 Publications 07-41, Sonderforschungsbereich 504, Universität Mannheim & Sonderforschungsbereich 504, University of Mannheim.
- Ingolf Dittmann & Ernst Maug, 2007. "Lower Salaries and No Options? On the Optimal Structure of Executive Pay," Journal of Finance, American Finance Association, vol. 62(1), pages 303-343, 02.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (The FMG Administration).
If references are entirely missing, you can add them using this form.