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Executive Pay and Performance: The Empirical Importance of the Participation Constraint

Author

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  • Ron Smith
  • Stefan Szymanski

Abstract

The low elasticity of top executive pay to performance in recent empirical work presents a puzzle since it is clear from the data that in practice both pay and performance measures have moved closely in line in recent years. This paper demonstrates that cross-section and time-series estimates of the pay performance elasticity differ significantly unless the effect of average executive pay is included. It is argued that this can be seen as the effect of the participation constraint in a principal agent model, more commonly known as "the going rate". The going rate must be paid to executives to deter them from taking up their outside option, which is the opportunity to leave the current firm and sign an incentive contract with another firm. Thus the outside option will depend on performance by other firms. Since performance is correlated between firms, this generates a larger time-series pay performance elasticity as perceived by the executive. The paper also considers the possibility that the going rate may induce incentive effects. The predictions of this argument are tested on a panel of data for large UK companies

Suggested Citation

  • Ron Smith & Stefan Szymanski, 1995. "Executive Pay and Performance: The Empirical Importance of the Participation Constraint," International Journal of the Economics of Business, Taylor & Francis Journals, vol. 2(3), pages 485-495.
  • Handle: RePEc:taf:ijecbs:v:2:y:1995:i:3:p:485-495
    DOI: 10.1080/758538018
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    Citations

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    Cited by:

    1. Ian Gregory-Smith & Brian G. M. Main, 2016. "Testing the Participation Constraint in the Executive Labour Market," Scottish Journal of Political Economy, Scottish Economic Society, vol. 63(4), pages 399-426, September.
    2. Frederick Guy, 2000. "CEO Pay, Shareholder Returns, and Accounting Profits," International Journal of the Economics of Business, Taylor & Francis Journals, vol. 7(3), pages 263-274.
    3. Stefan Szymanski & Ron Smith, 1997. "The English Football Industry: profit, performance and industrial structure," International Review of Applied Economics, Taylor & Francis Journals, vol. 11(1), pages 135-153.
    4. Marco, Marini, 1997. "Managers Compensation and Collusive Behaviour under Cournot Oligopoly," MPRA Paper 31871, University Library of Munich, Germany.

    More about this item

    Keywords

    JEL classifications: L14; J33;

    JEL classification:

    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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