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A Simple Theory of Managerial Talent, Pay Contracts and Wage Distribution

  • Yanhui Wu
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    This paper develops a simple theory of pay structures and pay levels across heterogeneous agents by bringing together optimal contracts inside the firm and competitive resource allocation in the market. The central idea is that more talented people tend to create greater value but face larger conflicts of interest in their employment relationship, and different pay contracts are optimally designed to mitigate different levels of agency problems. Sorted by their talent, people are stratified into production workers, self-employed, salaried managers with low-powered performance pay, and CEOs with high-powered equity-based pay. In a general equilibrium framework, I show that the sorting of managerial talent into pay contracts is tied to firm size. The theory highlights that high-powered incentive pay and large scales of operations cause the disproportionately large wage earnings at the top, and are the main source of income inequality. Market forces that reallocate resources from smaller to larger firms tend to increase the threshold talent for becoming a manager, increase the prevalence of high-powered incentive pay, raise the top earnings, and spread out the wage distribution.

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    File URL: http://cep.lse.ac.uk/pubs/download/dp1067.pdf
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    Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp1067.

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    Date of creation: Aug 2011
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    Handle: RePEc:cep:cepdps:dp1067
    Contact details of provider: Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

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