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Why Do Firms Use Incentives That Have No Incentive Effects?

  • Paul Oyer

This paper illustrates why firms might choose to implement stock option plans or other pay instruments that reward "luck." I consider a model where adjusting compensation contracts is costly and where employees' outside opportunities are correlated with their firms' performance. The model may help to explain the use and recent rise of broad-based stock option plans, as well as other financial instruments, even when these pay plans have no effect on employees' on-the-job behavior. The model suggests that agency theory's often-overlooked participation constraint may be an important determinant of some common compensation schemes, particularly for employees below the highest executive ranks. Copyright 2004 by The American Finance Association.

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Article provided by American Finance Association in its journal The Journal of Finance.

Volume (Year): 59 (2004)
Issue (Month): 4 (08)
Pages: 1619-1650

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Handle: RePEc:bla:jfinan:v:59:y:2004:i:4:p:1619-1650
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  1. Bengt Holmstrom, 1981. "Moral Hazard in Teams," Discussion Papers 471, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  2. Rochet, Jean-Charles & Stole, Lars A, 2002. "Nonlinear Pricing with Random Participation," Review of Economic Studies, Wiley Blackwell, vol. 69(1), pages 277-311, January.
  3. Robert W Drago & John S. Heywood, 1995. "The Choice of Payment Schemes: Australian Establishment Data," Working papers _006, University of Wisconsin - Milwaukee.
  4. Barro, Jason R & Barro, Robert J, 1990. "Pay, Performance, and Turnover of Bank CEOs," Journal of Labor Economics, University of Chicago Press, vol. 8(4), pages 448-81, October.
  5. Marianne Bertrand & Sendhil Mullainathan, 2000. "Do CEOs Set Their Own Pay? The Ones Without Principals Do," Working Papers 810, Princeton University, Department of Economics, Industrial Relations Section..
  6. Harris, Milton & Holstrom, Bengt, 1982. "A Theory of Wage Dynamics," Review of Economic Studies, Wiley Blackwell, vol. 49(3), pages 315-33, July.
  7. Benjamin E. Hermalin & Michael S. Weisbach, 1996. "Endogenously Chosen Boards of Directors and Their Monitoring of the CEO," Microeconomics 9602001, EconWPA, revised 09 Oct 1996.
  8. Robert Gibbons & Kevin Murphy, 1989. "Relative Performance Evaluation for Chief Executive Officers," Working Papers 628, Princeton University, Department of Economics, Industrial Relations Section..
  9. Patrick Legros & Steven A. Matthews, 1992. "Efficient and Nearly Efficient Partnerships," Discussion Papers 991R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  10. Rajesh K. Aggarwal & Andrew A. Samwick, 1999. "Executive Compensation, Strategic Competition, and Relative Performance Evaluation: Theory and Evidence," Journal of Finance, American Finance Association, vol. 54(6), pages 1999-2043, December.
  11. Alston, Lee J. & Higgs, Robert, 1982. "Contractual Mix in Southern Agriculture since the Civil War: Facts, Hypotheses, and Tests," The Journal of Economic History, Cambridge University Press, vol. 42(02), pages 327-353, June.
  12. Thomas, Jonathan & Worrall, Tim, 1988. "Self-enforcing Wage Contracts," Review of Economic Studies, Wiley Blackwell, vol. 55(4), pages 541-54, October.
  13. Eric Rasmusen, 1987. "Moral Hazard in Risk-Averse Teams," RAND Journal of Economics, The RAND Corporation, vol. 18(3), pages 428-435, Autumn.
  14. Card, David, 1986. "An Empirical Model of Wage Indexation Provisions in Union Contracts," Journal of Political Economy, University of Chicago Press, vol. 94(3), pages S144-75, June.
  15. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March.
  16. Beaudry, Paul & DiNardo, John, 1991. "The Effect of Implicit Contracts on the Movement of Wages over the Business Cycle: Evidence from Micro Data," Journal of Political Economy, University of Chicago Press, vol. 99(4), pages 665-88, August.
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