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Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts

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Author Info
John B. Donaldson
Natalia Gershun
Marc P. Giannoni

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Abstract

We consider a simple variant of the standard real business cycle model in which shareholders hire a self-interested executive to manage the firm on their behalf. Delegation gives rise to a generic conflict of interest mediated by a convex (option-like) compensation contract which is able to align the interests of managers and their shareholders. With such a compensation contract, a given increase in the firm's output generated by an additional unit of physical investment results in a more than proportional increase in the manager's income. We find that incentive contracts of this form can easily result in an indeterminate general equilibrium, with business cycles driven by self-fulfilling fluctuations in the manager's expectations. These expectations are unrelated to fundamentals. Arbitrarily large fluctuations in macroeconomic variables may possibly result.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15165.

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Date of creation: Jul 2009
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Handle: RePEc:nbr:nberwo:15165

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Find related papers by JEL classification:
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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This page was last updated on 2009-11-25.

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