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An Equilibrium Model of Managerial Compensation

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  • Michael Magill
  • Martine Quinzii

Abstract

This paper studies a general equilibrium model with two groups of agents, investors (shareholders) and managers of firms, in which managerial effort is not observable and influences the probabilities of firms’ outcomes. Shareholders of each firm offer the manager an incentive contract which maximizes the firm’s market value, under the assumption that the financial markets are complete relative to the possible outcomes of the firms. The paper studies two sources of inefficiency of equilibrium. First, when investors are risk averse and effort influences probability, market-value maximization differs from maximization of expected utility. Second, because the optimal contract exploits all sources of information for inferring managerial effort, when firms’ outputs are correlated the contract of a manager depends on the outcomes of other firms. This leads to an external effect of the effort of one manager on the compensation of other managers, which market-value maximization ignores. We show that under typical conditions these two effects lead to an under-provision of effort in equilibrium. These inefficiencies disappear however if each firm is replicated, and in the limit there is a continuum of firms of each type.

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File URL: http://www.usc.edu/dept/LAS/economics/IEPR/Working%20Papers/IEPR_05.22_%5BMagill,Quinzii%5D.pdf
File Function: First version, 2005
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Bibliographic Info

Paper provided by Institute of Economic Policy Research (IEPR) in its series IEPR Working Papers with number 05.22.

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Length: 28 pages
Date of creation: Mar 2005
Date of revision:
Handle: RePEc:scp:wpaper:05-22

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  1. Edward C Prescott & Robert M Townsend, 1997. "General Competitive Analysis in an Economy with Private Information," Levine's Working Paper Archive 1578, David K. Levine.
  2. Rogerson, William P, 1985. "The First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, Econometric Society, vol. 53(6), pages 1357-67, November.
  3. Mookherjee, Dilip, 1984. "Optimal Incentive Schemes with Many Agents," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 51(3), pages 433-46, July.
  4. Jensen, M.C. & Murphy, K.J., 1988. "Performance Pay And Top Management Incentives," Papers, Rochester, Business - Managerial Economics Research Center 88-04, Rochester, Business - Managerial Economics Research Center.
  5. Edward C Prescott & Robert M Townsend, 2010. "Pareto Optima and Competitive Equilibria With Adverse Selection and Moral Hazard," Levine's Working Paper Archive 2069, David K. Levine.
  6. Michael Magill & Martine Quinzii, 2006. "Common Shocks and Relative Compensation," Annals of Finance, Springer, Springer, vol. 2(4), pages 407-420, October.
  7. Kocherlakota, Narayana R., 1998. "The effects of moral hazard on asset prices when financial markets are complete," Journal of Monetary Economics, Elsevier, Elsevier, vol. 41(1), pages 39-56, February.
  8. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, Econometric Society, vol. 56(5), pages 1177-90, September.
  9. Magill, Michael & Quinzii, Martine, 2002. "Capital market equilibrium with moral hazard," Journal of Mathematical Economics, Elsevier, vol. 38(1-2), pages 149-190, September.
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Cited by:
  1. Guido Maretto, 2011. "Contracts and Market: Risk Sharing with Hidden Types," Working Papers ECARES ECARES 2011-005, ULB -- Universite Libre de Bruxelles.

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