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Risk aversion, performance pay, and the principal-agent problem

  • Joseph G. Haubrich

This paper calculates numerical solutions to the principal-agent problem and compares the results to the stylized facts of CEO compensation. The numerical predictions come from parameterizing the models of Grossman and Hart and of Holmstrom and Milgrom. While the correct incentives for a CEO can greatly enhance a firm's performance, providing such incentives need not be expensive. For many parameter values, CEO compensation need only increase by about $10 for every $1,000 of additional shareholder value; for some values, the amount is 0.003 cents. The paper thus answers two challenges posed by Jensen: that principal-agent theory does not yield quantitative predictions, and that CEO compensation is insufficiently sensitive to firm performance.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 9118.

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Date of creation: 1991
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Handle: RePEc:fip:fedcwp:9118
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  1. Baker, G.P. & Jensen, M.C. & Murphy, K.J., 1988. "Compensation And Incentives: Practice Vs. Theory," Papers 88-05, Rochester, Business - Managerial Economics Research Center.
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  4. Sanford J Grossman & Oliver D Hart, 2001. "An Analysis of the Principal-Agent Problem," Levine's Working Paper Archive 391749000000000339, David K. Levine.
  5. N/A, 1983. "Chapter II. The World Economy," National Institute Economic Review, National Institute of Economic and Social Research, vol. 104(1), pages 21-31, May.
  6. Weisbach, Michael S., 1988. "Outside directors and CEO turnover," Journal of Financial Economics, Elsevier, vol. 20(1-2), pages 431-460, January.
  7. Holmstrom, Bengt & Milgrom, Paul, 1987. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, Econometric Society, vol. 55(2), pages 303-28, March.
  8. Joseph G. Haubrich, 2001. "Sharing with a risk-neutral agent," Economic Review, Federal Reserve Bank of Cleveland, issue Q I, pages 2-8.
  9. Spitze, R.G.F., 1983. "Series E, Agricultural Economics," Illinois Agricultural Economics Staff Paper 244634, University of Illinois at Urbana-Champaign, Department of Agricultural and Consumer Economics.
  10. Michael C. Jensen & Kevin J. Murphy, 1990. "Ceo Incentives - It'S Not How Much You Pay, But How," Journal of Applied Corporate Finance, Morgan Stanley, vol. 3(3), pages 36-49.
  11. anonymous, 1983. "New Zealand economic chronology 1982," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 46, january/f.
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  14. N/A, 1983. "Chapter I. The Home Economy," National Institute Economic Review, National Institute of Economic and Social Research, vol. 106(1), pages 5-25, November.
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  18. N/A, 1983. "Chapter I. The Home Economy," National Institute Economic Review, National Institute of Economic and Social Research, vol. 105(1), pages 5-18, August.
  19. M. J. DRISCOLL & J. J. A. PLESSIS & J.L. Ford, 1983. "Monetary Aggregates and Economic Activity: Reply," South African Journal of Economics, Economic Society of South Africa, vol. 51(2), pages 217-222, 06.
  20. N/A, 1983. "Chapter I. the Home Economy," National Institute Economic Review, National Institute of Economic and Social Research, vol. 104(1), pages 6-20, May.
  21. anonymous, 1983. "International economic situation and outlook," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 46, january/f.
  22. -, 1983. "Notas sobre la economía brasileña en 1982," Oficina de la CEPAL en Brasilia (Estudios e Investigaciones) 28369, Naciones Unidas Comisión Económica para América Latina y el Caribe (CEPAL).
  23. Kandel, Shmuel & Stambaugh, Robert F., 1991. "Asset returns and intertemporal preferences," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 39-71, February.
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  25. Sappington, David, 1983. "Limited liability contracts between principal and agent," Journal of Economic Theory, Elsevier, vol. 29(1), pages 1-21, February.
  26. N/A, 1983. "Chapter I. the Home Economy," National Institute Economic Review, National Institute of Economic and Social Research, vol. 103(1), pages 6-29, February.
  27. Caballero, Ricardo J., 1990. "Consumption puzzles and precautionary savings," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 113-136, January.
  28. Sheshinski, Eytan, 1989. "Note on the shape of the optimum income tax schedule," Journal of Public Economics, Elsevier, vol. 40(2), pages 201-215, November.
  29. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, vol. 65(5), pages 900-922, December.
  30. anonymous, 1983. "The budget and macro-economic policy," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 46, september.
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