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Sensitivity of CEO Pay to Shareholder Wealth in a Dynamic Agency Model

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  • Gian Luca Clementi
  • Thomas F. Cooley

Abstract

The empirical literature has pointed out several stylized facts about Executive Compensation Schemes. In particular, with respect to the sensitivity of compensation to shareholder wealth, three findings stand out. First, the short-run response of compensation to performance is lower than the one implied by static agency models. Second, the cumulative response is considerably higher. Finally, the sensitivity is inversely proportional to firm size. In this paper, building on work by Wang (1997), we model the relationship between shareholders and their CEO as a repeated principal-agent relationship with hidden action. We introduce two innovations with respect to the existing literture. First, the scale of operations (level of capital stock) is determined optimally by the CEO, conditionally on the provisions of the compensation contract and on the evolution of the technology's productivity. Second, and most importantly, in our setup the action of the CEO has an impact on both current and future levels of firm's productivity. We are able to show by means of numerical simulation that the optimal compensation scheme in this environment displays features that are qualitatively in line with the empirical evidence on pay-performance sensitivity.

Suggested Citation

  • Gian Luca Clementi & Thomas F. Cooley, "undated". "Sensitivity of CEO Pay to Shareholder Wealth in a Dynamic Agency Model," GSIA Working Papers 2002-E13, Carnegie Mellon University, Tepper School of Business.
  • Handle: RePEc:cmu:gsiawp:631722219
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    References listed on IDEAS

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    1. Jonathan Thomas & Tim Worrall, 1988. "Self-Enforcing Wage Contracts," Review of Economic Studies, Oxford University Press, vol. 55(4), pages 541-554.
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    3. Acharya, Viral V. & John, Kose & Sundaram, Rangarajan K., 2000. "On the optimality of resetting executive stock options," Journal of Financial Economics, Elsevier, pages 65-101.
    4. Gian Luca Clementi & Thomas Cooley & Sonia Di Giannatale, 2010. "A Theory of Firm Decline," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 13(4), pages 861-885, October.
    5. Haubrich, Joseph G, 1994. "Risk Aversion, Performance Pay, and the Principal-Agent Problem," Journal of Political Economy, University of Chicago Press, pages 258-276.
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    Cited by:

    1. Clementi, Gian Luca & Cooley, Thomas F. & Wang, Cheng, 2006. "Stock grants as a commitment device," Journal of Economic Dynamics and Control, Elsevier, vol. 30(11), pages 2191-2216, November.
    2. Jorge Aseff & Manuel Santos, 2005. "Stock options and managerial optimal contracts," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), pages 813-837.
    3. Gian Luca Clementi & Hugo Hopenhayn, "undated". "A Theory of Financing Constraints and Firm Dynamics," GSIA Working Papers 2002-E9, Carnegie Mellon University, Tepper School of Business.

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