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Incentives, CEO Compensation and Shareholder Wealth in a Dynamic Agency Model

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  • Wang, Cheng
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    Abstract

    M. Jensen and K. Murphy (1990,J. Polit. Econ.98, 225ï¾–264) argue that the observed payï¾–performance sensitivity of CEO compensation is too low to be consistent with formal agency theory. This paper uses a dynamic agency model to offer a resolution of the Jensen and Murphy puzzle. We show that the dynamic agency model can predict either a positive or a negative payï¾–performance sensitivity, depending on the parameter values of the model and the distribution of the CEOs' initial expected discounted utilities. For a large variety of parameter values and for properly chosen distributions of initial CEO expected discounted utilities, our model is capable of generating data where the payï¾–performance sensitivity is significantly positive but very small, as in Jensen and Murphy's data. The key to our result is a compensation rigidity that is created endogenously by the optimal dynamic contract.Journal of Economic LiteratureClassification Numbers: C63, D82, G30. *1 This paper was motivated by a conversation with Narayana Kocherlakota to whom I am also indebted for his advice. I thank Steve Williamson for his guidance and support. I thank the associate editor and three anonymous referees for their useful comments and suggestions. I am also grateful to Dean Corbae, Ed Green, Andreas Hornstein, Peter Howitt, Arthur Robson, Steve Spear, and seminar participants at the Universities of Iowa, Western Ontario, Rochester, Queen's, Chicago, Federal Reserve Bank of Richmond, Iowa State, Toronto, Simon Fraser, Carnegie-Mellon, and Illinois for discussions and comments. Financial support from the Social Science and Humanities Research Council of Canada is acknowledged. *2 E. PrescottN. Wallace, Eds.

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    Bibliographic Info

    Paper provided by Iowa State University, Department of Economics in its series Staff General Research Papers with number 5170.

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    Date of creation: 01 Sep 1997
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    Publication status: Published in Journal of Economic Theory, September 1997, vol. 76 no. 1, pp. 72-105
    Handle: RePEc:isu:genres:5170

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    Postal: Iowa State University, Dept. of Economics, 260 Heady Hall, Ames, IA 50011-1070
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    Web page: http://www.econ.iastate.edu
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    Cited by:
    1. Quadrini, Vincenzo, 2004. "Investment and liquidation in renegotiation-proof contracts with moral hazard," Journal of Monetary Economics, Elsevier, vol. 51(4), pages 713-751, May.
    2. Arantxa Jarque, 2010. "Hidden effort, learning by doing, and wage dynamics," Economic Quarterly, Federal Reserve Bank of Richmond, issue 4Q, pages 339-372.
    3. Pierre Chaigneau, 2012. "The Optimal Timing of CEO Compensation," Cahiers de recherche 1207, CIRPEE.
    4. Vincenzo Quadrini & Ramon Marimon & Thomas Cooley, 2012. "Risky Investments with Limited Commitment," 2012 Meeting Papers 603, Society for Economic Dynamics.
    5. Spear, Stephen E. & Wang, Cheng, 2005. "When to Fire a CEO: Optimal Termination in Dynamic Contracts," Staff General Research Papers 11443, Iowa State University, Department of Economics.
    6. Clementi, Gian Luca & Cooley, Thomas F. & Wang, Cheng, 2006. "Stock Grants As a Commitment Device," Staff General Research Papers 12300, Iowa State University, Department of Economics.
    7. Gian Luca Clementi & Thomas F. Cooley, 2009. "Executive Compensation: Facts," NBER Working Papers 15426, National Bureau of Economic Research, Inc.
    8. Itza Curiel & Sonia Di Giannatale & Juan Herrera & Katya Rodríguez, 2012. "Pareto Frontier of a Dynamic Principal–Agent Model with Discrete Actions: An Evolutionary Multi-Objective Approach," Computational Economics, Society for Computational Economics, vol. 40(4), pages 415-443, December.
    9. Wang, Cheng, 2011. "Termination of dynamic contracts in an equilibrium labor market model," Journal of Economic Theory, Elsevier, vol. 146(1), pages 74-110, January.
    10. Pierre Chaigneau, 2010. "The Optimal Timing of Executive Compensation," FMG Discussion Papers dp660, Financial Markets Group.
    11. Emilio Espino & Juan M. Sanchez, 2010. "Risk sharing, investment, and incentives in the neoclassical growth model," Economic Quarterly, Federal Reserve Bank of Richmond, issue 4Q, pages 399-416.
    12. Giat, Yahel & Subramanian, Ajay, 2013. "Dynamic contracting under imperfect public information and asymmetric beliefs," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2833-2861.

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