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Has Moral Hazard Become a More Important Factor in Managerial Compensation?

  • George-Levi Gayle
  • Robert A. Miller

The theory of moral hazard predicts that since the activities of managers are hard to monitor directly, managerial compensation is tied to the profitability of the firms they manage. In this empirical study we investigate the hypothesis that the secular trends in managerial compensation can be attributed to the changing importance of moral hazard that affect the optimal contract through shifts in the distribution of the abnormal returns to the firm. We estimate a principal agent model of moral hazard controlling for heterogeneity across sectors, different measure of firm size, leverage, and executive position within the firm hierarchy. Our two data sets on three industrial sectors, which together span a sixty year period, strengthens past research that documents the increasing level of total executive compensation and the sensitivity of compensation to firm performance over the last two decades. Within each data set almost all variation in executive compensation is explained by the firms abnormal returns and the controls in our empirical model. We find that had moral hazard not been a factor, compensation in the three sectors would have increased at the same rate as national income, much lower than the average increase that actually occurred. We find little evidence to suggest that managerial tastes have changed, or that the nonpecuniary benefits to managers deviating from shareholder interests have increased. There are two factors driving the sharply increased costs of moral hazard. First, increased dispersion of abnormal returns has led to deterioration in the signal shareholders receive about managerial activities, raising the welfare costs of moral hazard in two sectors we investigate. Second, we find the changing composition of firms in all sectors has increased average firm size, and we find that managing larger firms increases the discrepancy between shareholder and managerial interests.

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Paper provided by Carnegie Mellon University, Tepper School of Business in its series GSIA Working Papers with number 2005-E58.

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Date of creation: Nov 2005
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Handle: RePEc:cmu:gsiawp:1131565224
Contact details of provider: Postal: Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213-3890
Web page: http://www.tepper.cmu.edu/

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  1. Brian J. Hall & Jeffrey B. Liebman, 1998. "Are CEOs Really Paid Like Bureaucrats?," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 653-691, August.
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  3. Rajesh Aggarwal & Andrew A. Samwick, 1998. "The Other Side of the Tradeoff: The Impact of Risk on Executive Compensation," NBER Working Papers 6634, National Bureau of Economic Research, Inc.
  4. Sanford Grossman & Oliver Hart, . "An Analysis of the Principal-Agent Problem," Rodney L. White Center for Financial Research Working Papers 15-80, Wharton School Rodney L. White Center for Financial Research.
  5. Margiotta, Mary M & Miller, Robert A, 2000. "Managerial Compensation and the Cost of Moral Hazard," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 41(3), pages 669-719, August.
  6. Joseph G. Haubrich, 1991. "Risk aversion, performance pay, and the principal-agent problem," Working Paper 9118, Federal Reserve Bank of Cleveland.
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  9. Jensen, M.C. & Murphy, K.J., 1988. "Performance Pay And Top Management Incentives," Papers 88-04, Rochester, Business - Managerial Economics Research Center.
  10. George-Levi Gayle & Robert Miller, . "Identifying and Testing Models of Managerial Compensations," GSIA Working Papers 2009-E7, Carnegie Mellon University, Tepper School of Business.
  11. Peter F. Kostiuk, 1990. "Firm Size and Executive Compensation," Journal of Human Resources, University of Wisconsin Press, vol. 25(1), pages 90-105.
  12. Murphy, Kevin J., 1999. "Executive compensation," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 38, pages 2485-2563 Elsevier.
  13. Mathias Dewatripont & Patrick Bolton, 2005. "Contract theory," ULB Institutional Repository 2013/9543, ULB -- Universite Libre de Bruxelles.
  14. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March.
  15. Masson, Robert Tempest, 1971. "Executive Motivations, Earnings, and Consequent Equity Performance," Journal of Political Economy, University of Chicago Press, vol. 79(6), pages 1278-92, Nov.-Dec..
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  17. Fudenberg, Drew & Holmstrom, Bengt & Milgrom, Paul, 1990. "Short-term contracts and long-term agency relationships," Journal of Economic Theory, Elsevier, vol. 51(1), pages 1-31, June.
  18. Kevin J. Murphy & Ján Zábojník, 2004. "CEO Pay and Appointments: A Market-Based Explanation for Recent Trends," American Economic Review, American Economic Association, vol. 94(2), pages 192-196, May.
  19. Cuñat, Vicente & Guadalupe, Maria, 2006. "Globalization and the Provision of Incentives Inside the Firm," CEPR Discussion Papers 5950, C.E.P.R. Discussion Papers.
  20. Oliver E. Williamson, 1967. "Hierarchical Control and Optimum Firm Size," Journal of Political Economy, University of Chicago Press, vol. 75, pages 123.
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