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Changes in probability distributions and the form of compensation contracts

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  • Pierre Chaigneau

    (HEC Montreal)

Abstract

We consider a standard principal-agent setting where the first-order approach to the effort choice problem applies. We decompose the effect of a change in the probability distribution of performances on the form of the optimal contract into three additive components. We also consider the specific cases of a linear likelihood ratio, a rightward or leftward translation of the likelihood ratio, and CRRA utility. The results shed light on the differences between the optimal contracts derived in the literature, notably depending on whether a linear likelihood ratio or a lognormally distributed performance measure is assumed.

Suggested Citation

  • Pierre Chaigneau, 2015. "Changes in probability distributions and the form of compensation contracts," Economic Theory Bulletin, Springer;Society for the Advancement of Economic Theory (SAET), vol. 3(2), pages 223-232, October.
    • Handle: RePEc:spr:etbull:v:3:y:2015:i:2:d:10.1007_s40505-014-0051-7
    DOI: 10.1007/s40505-014-0051-7
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    References listed on IDEAS

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    1. Rogerson, William P, 1985. "The First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 53(6), pages 1357-1367, November.
    2. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-1190, September.
    3. Ingolf Dittmann & Ernst Maug, 2007. "Lower Salaries and No Options? On the Optimal Structure of Executive Pay," Journal of Finance, American Finance Association, vol. 62(1), pages 303-343, February.
    4. HOLMSTROM, Bengt, 1979. "Moral hazard and observability," LIDAM Reprints CORE 379, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
    5. Ingolf Dittmann & Ernst Maug & Oliver Spalt, 2010. "Sticks or Carrots? Optimal CEO Compensation when Managers Are Loss Averse," Journal of Finance, American Finance Association, vol. 65(6), pages 2015-2050, December.
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    7. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
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    More about this item

    Keywords

    Executive compensation; First-order approach; Likelihood ratio; Performance measure; Principal-agent model;
    All these keywords.

    JEL classification:

    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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