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CEO Incentives and Firm Size

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  • George P. Baker
  • Brian J. Hall
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    Abstract

    What determines CEO incentives? A confusion exists among both academics and practitioners about how to measure the strength of CEO incentives, and how to reconcile the enormous differences in pay sensitivities between executives in large and small firms. We show that while one measure of CEO incentives (the dollar change in CEO wealth per dollar change in firm value) falls by a factor of ten between firms in the smallest and largest deciles in our sample, another measure of CEO incentives (the value of CEO equity stakes) increases by roughly the same magnitude. We resolve the confusion about which of these measures better reflects CEO incentives by developing and solving a model that allows CEO productivity to differ for firms of different sizes. The crucial parameter is shown to be the elasticity of CEO productivity with respect to firm size. Our empirical results suggest that CEO marginal products rise significantly, and overall CEO incentives are roughly constant or decline slightly with firm size. We also show that the appropriate measure of incentives depends on the type of CEO activity being considered. For activities whose dollar impact is the same for large and small firms (such as the purchase of a corporate jet), the dollars-on-dollars measure is appropriate, and large firms suffer significant agency problems due to their weak incentives. For activities whose percentage impact is similar across firms of different sizes (such as a corporate reorganization) the equity stake measure is better, and the incentive problem faced by large firms is not as severe. Finally, using a multi-task model, we discuss the implication of our findings for the design of control systems.

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    File URL: http://www.nber.org/papers/w6868.pdf
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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6868.

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    Date of creation: Dec 1998
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    Publication status: published as Baker, George P. and Brian J. Hall. "CEO Incentives and Firm Size," Journal of Labor Economics, 2004, v22(4,Oct), 767-798.
    Handle: RePEc:nbr:nberwo:6868

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    1. Robert Gibbons & Kevin Murphy, 1989. "Relative Performance Evaluation for Chief Executive Officers," Working Papers 628, Princeton University, Department of Economics, Industrial Relations Section..
    2. Murphy, Kevin J., 1985. "Corporate performance and managerial remuneration : An empirical analysis," Journal of Accounting and Economics, Elsevier, vol. 7(1-3), pages 11-42, April.
    3. 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.
    4. Haubrich, Joseph G, 1994. "Risk Aversion, Performance Pay, and the Principal-Agent Problem," Journal of Political Economy, University of Chicago Press, vol. 102(2), pages 258-76, April.
    5. Sherwin Rosen, 1990. "Contracts and the Market for Executives," NBER Working Papers 3542, National Bureau of Economic Research, Inc.
    6. Brian J. Hall, 1998. "The Pay to Performance Incentives of Executive Stock Options," NBER Working Papers 6674, National Bureau of Economic Research, Inc.
    7. Garen, John E, 1994. "Executive Compensation and Principal-Agent Theory," Journal of Political Economy, University of Chicago Press, vol. 102(6), pages 1175-99, December.
    8. Paul L. Joskow & Nancy L. Rose, 1994. "CEO Pay and Firm Performance: Dynamics, Asymmetries, and Alternative Performance Measures," NBER Working Papers 4976, National Bureau of Economic Research, Inc.
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