Understanding CEO-Employee compensation dynamics: An agent-based simulation approach

CEO compensation has often been examined from the top down, i.e., as the outcome of a negotiation between the CEO, the board of directors, and the shareholders. While these approaches have provided valuable insights into the nature of CEO compensation and its relations with firm performance and intra-firm inequality, we believe they leave aside the internal decision-making dynamics of CEOs and employees. To fill this research gap, we develop an agent-based model built on the NK framework in which a CEO compensated for long-term firm performance interacts with several employees rewarded for short-term departmental performance. This temporal dichotomy in their respective compensation functions creates a potential temporal misalignment of incentives. By varying the horizon considered by the CEO to make their decisions, we examine how this temporal (mis)alignment of incentives shapes firm performance and pay inequality between the CEO and the employees. Our findings suggest that aligning the CEO's horizon with the employees' short-term incentives yields the highest performance, raising both the level attained and the speed of improvement across all task environments examined. This finding contrasts with the usual advice given in CEO compensation research, which is to avoid short-termism. Furthermore, the model shows that the longest horizon examined produces both the lowest performance and the highest pay inequality. This pattern, commonly attributed to managerial power, emerges in our model from incentive misalignment alone, without agents holding any power over their own compensation.