A simple explanation of the relative performance evaluation puzzle
AbstractWe study a simple moral hazard model in which two risk-neutral owners establish incentives for their risk-averse managers to exert effort. Because the probability distributions over output realizations depend on a common aggregate shock, optimal contracts make the compensation of each manager contingent on own performance but also on a performance benchmark—the performance of the other firm. If the marginal return of effort depends on the aggregate state, optimal contracts are not monotonically decreasing in the performance benchmark. This provides a simple explanation of the Relative Performance Evaluation (RPE) Puzzle—the documented lack of a negative relationship between CEO compensation and comparative performance measures, such as industry or market performance. Our simple model can also explain one-sided RPE—the documented tendency to insulate a CEO's rewards from bad luck, but not from good luck. We clarify that our results are robust in several dimensions and we discuss other applications of our findings.
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Bibliographic InfoPaper provided by Universidad Carlos III de Madrid in its series Open Access publications from Universidad Carlos III de Madrid with number info:hdl:10016/4824.
Length: 542 p.
Date of creation: Jul 2006
Date of revision:
Publication status: Published in Review of Economic Dynamics (2006-07) v. 9, p.525-540
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Web page: http://www.uc3m.es
Relative performance evaluation; Optimal contracts; Executive compensation;
Find related papers by JEL classification:
- C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- M52 - Business Administration and Business Economics; Marketing; Accounting - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects
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