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Incentives, CEO Compensation, and Shareholder Wealth in a Dynamic Agency Model

  • Wang, Cheng

M. Jensen and K. Murphy (1990,J. Polit. Econ.98, 225ï¾–264) argue that the observed payï¾–performance sensitivity of CEO compensation is too low to be consistent with formal agency theory. This paper uses a dynamic agency model to offer a resolution of the Jensen and Murphy puzzle. We show that the dynamic agency model can predict either a positive or a negative payï¾–performance sensitivity, depending on the parameter values of the model and the distribution of the CEOs' initial expected discounted utilities. For a large variety of parameter values and for properly chosen distributions of initial CEO expected discounted utilities, our model is capable of generating data where the payï¾–performance sensitivity is significantly positive but very small, as in Jensen and Murphy's data. The key to our result is a compensation rigidity that is created endogenously by the optimal dynamic contract.Journal of Economic LiteratureClassification Numbers: C63, D82, G30. *1 This paper was motivated by a conversation with Narayana Kocherlakota to whom I am also indebted for his advice. I thank Steve Williamson for his guidance and support. I thank the associate editor and three anonymous referees for their useful comments and suggestions. I am also grateful to Dean Corbae, Ed Green, Andreas Hornstein, Peter Howitt, Arthur Robson, Steve Spear, and seminar participants at the Universities of Iowa, Western Ontario, Rochester, Queen's, Chicago, Federal Reserve Bank of Richmond, Iowa State, Toronto, Simon Fraser, Carnegie-Mellon, and Illinois for discussions and comments. Financial support from the Social Science and Humanities Research Council of Canada is acknowledged. *2 E. PrescottN. Wallace, Eds.

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Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 76 (1997)
Issue (Month): 1 (September)
Pages: 72-105

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Handle: RePEc:eee:jetheo:v:76:y:1997:i:1:p:72-105
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  1. Phelan Christopher, 1995. "Repeated Moral Hazard and One-Sided Commitment," Journal of Economic Theory, Elsevier, vol. 66(2), pages 488-506, August.
  2. Jensen, Michael C & Murphy, Kevin J, 1990. "Performance Pay and Top-Management Incentives," Journal of Political Economy, University of Chicago Press, vol. 98(2), pages 225-64, April.
  3. 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.
  4. Abreu, Dilip & Pearce, David & Stacchetti, Ennio, 1990. "Toward a Theory of Discounted Repeated Games with Imperfect Monitoring," Econometrica, Econometric Society, vol. 58(5), pages 1041-63, September.
  5. Andrew Atkeson & Robert E Lucas, 2010. "On Efficient Distribution with Private Information," Levine's Working Paper Archive 2179, David K. Levine.
  6. Phelan, Christopher & Townsend, Robert M, 1991. "Computing Multi-period, Information-Constrained Optima," Review of Economic Studies, Wiley Blackwell, vol. 58(5), pages 853-81, October.
  7. Wang, Cheng, 1995. "Dynamic Insurance with Private Information and Balanced Budgets," Review of Economic Studies, Wiley Blackwell, vol. 62(4), pages 577-95, October.
  8. Dilip Abreu & David Pearce & Ennio Stacchetti, 2010. "Towards a Theory of Discounted Repeated Games with Imperfect Monitoring," Levine's Working Paper Archive 199, David K. Levine.
  9. 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.
  10. Phelan, Christopher, 1994. "Incentives and Aggregate Shocks," Review of Economic Studies, Wiley Blackwell, vol. 61(4), pages 681-700, October.
  11. Spear, Stephen E & Srivastava, Sanjay, 1987. "On Repeated Moral Hazard with Discounting," Review of Economic Studies, Wiley Blackwell, vol. 54(4), pages 599-617, October.
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