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A Calibratable Model of Optimal CEO Incentives in Market Equilibrium

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  • Alex Edmans
  • Xavier Gabaix
  • Augustin Landier

Abstract

This paper presents a unified framework for understanding the determinants of both CEO incentives and total pay levels in competitive market equilibrium. It embeds a modified principal-agent problem into a talent assignment model to endogenize both elements of compensation. The model's closed form solutions yield testable predictions for how incentives should vary across firms under optimal contracting. In particular, our calibrations show that the negative relationship between the CEO's effective equity stake and firm size is quantitatively consistent with efficiency and need not reflect rent extraction. Our model and data both also imply that the dollar change in wealth for a percentage change in firm value, scaled by annual pay, is independent of firm size. This may render it an attractive incentive measure as it is comparable between firms and over time. The theory also predicts a positive relationship between pay volatility and firm volatility, and that risk and effort affect total pay along the cross-section but not in the aggregate. Finally, we demonstrate that incentive compensation is effective at solving large agency problems, such as selecting corporate strategy, but smaller issues such as perk consumption are best addressed through direct monitoring.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13372.

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Date of creation: Sep 2007
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Handle: RePEc:nbr:nberwo:13372

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Citations

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Cited by:
  1. Giannetti, Mariassunta, 2011. "Serial CEO incentives and the structure of managerial contracts," Journal of Financial Intermediation, Elsevier, Elsevier, vol. 20(4), pages 633-662, October.
  2. Hanno Lustig & Chad Syverson & Stijn Van Nieuwerburgh, 2009. "Technological Change and the Growing Inequality in Managerial Compensation," NBER Working Papers 14661, National Bureau of Economic Research, Inc.
  3. 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.
  4. Antonio Falato & Dalida Kadyrzhanova, 2012. "Optimal CEO incentives and industry dynamics," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 2012-78, Board of Governors of the Federal Reserve System (U.S.).

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