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Output-based Pay: Incentives or Sorting?

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  • Edward P. Lazear

Abstract

Variable pay, defined as pay that is tied to some measure of a firm's output, has become more important for executives of the typical American firm. Variable pay is usually touted as a way to provide incentives to managers whose interests may not be perfectly aligned with those of owners. The incentive justification for variable pay has well-known theoretical problems and also appears to be inconsistent with much of the data. Alternative explanations are considered. One that has not received much attention, but that is consistent with may of the facts, is selection. Managers and industry specialists may have information about a firm's prospects that is unavailable to outside investors. In order to induce managers to be truthful about prospects, owners may require managers to 'put their money where their mouths are,' forcing them to extract some of their compensation in the form of variable pay. The selection or sorting explanation is consistent with the low elasticities of pay to output that are commonly observed, with the fact that the elasticity is higher in small and new firms, and with the fact that variable pay is more prevalent in industries with very technical production technologies. It does not explain why some firms give stock options even to very low-level workers.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7419.

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Date of creation: Nov 1999
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Handle: RePEc:nbr:nberwo:7419

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  1. Hall, Robert E & Lazear, Edward P, 1984. "The Excess Sensitivity of Layoffs and Quits to Demand," Journal of Labor Economics, University of Chicago Press, vol. 2(2), pages 233-57, April.
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  7. Edward P. Lazear, 1999. "Personnel Economics: Past Lessons and Future Directions," NBER Working Papers 6957, National Bureau of Economic Research, Inc.
  8. Kandel, Eugene & Lazear, Edward P, 1992. "Peer Pressure and Partnerships," Journal of Political Economy, University of Chicago Press, vol. 100(4), pages 801-17, August.
  9. 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.
  10. Lazear, Edward P, 1986. "Salaries and Piece Rates," The Journal of Business, University of Chicago Press, vol. 59(3), pages 405-31, July.
  11. Myerson, Roger B, 1983. "Mechanism Design by an Informed Principal," Econometrica, Econometric Society, vol. 51(6), pages 1767-97, November.
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Cited by:
  1. Bushman, Robert M. & Smith, Abbie J., 2001. "Financial accounting information and corporate governance," Journal of Accounting and Economics, Elsevier, vol. 32(1-3), pages 237-333, December.
  2. Origo, Federica, 2009. "Flexible pay, firm performance and the role of unions. New evidence from Italy," Labour Economics, Elsevier, vol. 16(1), pages 64-78, January.
  3. William Fuchs, 2005. "Contracting with Repeated Moral Hazard and Private Evaluations," 2005 Meeting Papers 431, Society for Economic Dynamics.
  4. Jaag, Christian, 2006. "Teacher Incentives," MPRA Paper 340, University Library of Munich, Germany.
  5. Fredrik Andersson & Matthew Freedman & John Haltiwanger & Julia Lane & Kathryn Shaw, 2009. "Reaching for the Stars: Who Pays for Talent in Innovative Industries?," Economic Journal, Royal Economic Society, vol. 119(538), pages F308-F332, 06.
  6. Campbell, Benjamin A., 2003. "Firm Volatility and Stock Option Incidence," Institute for Research on Labor and Employment, Working Paper Series qt7gt1r0pn, Institute of Industrial Relations, UC Berkeley.
  7. Pierre Malgrange & Jean-Louis Rullière & Marie-Claire Villeval, 2004. "L'économie des ressources humaines : pouvoir et limites des incitations. Aperçu théorique et présentation générale," Économie et Prévision, Programme National Persée, vol. 164(3), pages 1-15.
  8. repec:nbr:nberwo:14272 is not listed on IDEAS
  9. Edward P. Lazear, 2004. "Salaire à la performance : incitation ou sélection," Économie et Prévision, Programme National Persée, vol. 164(3), pages 17-25.
  10. Bergman, Nittai K. & Jenter, Dirk, 2007. "Employee sentiment and stock option compensation," Journal of Financial Economics, Elsevier, vol. 84(3), pages 667-712, June.
  11. Kshitija Dixit & Rupayan Pal, 2010. "The impact of group incentives on performance of small firms: Hausman-Taylor estimates," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 31(6), pages 403-414.

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