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Optimal CEO incentives and industry dynamics

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Abstract

This paper develops a competitive equilibrium model of CEO compensation and industry dynamics. CEOs make product pricing and product improvement decisions subject to shareholders' compensation choices and idiosyncratic shocks to product quality. The choice of high-powered incentives optimally trades off the benefits from expected product improvements and the associated agency costs. In market equilibrium, the interaction between CEO pay and product market decisions affects the stationary distribution of firms. We characterize a dynamic feedback effect of industry structure on CEO incentives. As a result of this effect, we predict that the performance-based component of CEO pay should be higher, (i) across industries, when the degree of heterogeneity of industry structure is lower; (ii) within industries, when firms are laggards with respect to their industry peers. We empirically estimate pay-performance sensitivity for a large sample of U.S. CEOs and other top executives over the 1993 to 2004 period and find strong support for our theory. Our results offer a novel product market rationale for the increased reliance of CEO pay on bonuses and stock options over the 1990s.

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  • Antonio Falato & Dalida Kadyrzhanova, 2012. "Optimal CEO incentives and industry dynamics," Finance and Economics Discussion Series 2012-78, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2012-78
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    Cited by:

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    2. Alex Edmans & Xavier Gabaix & Augustin Landier, 2007. "A Calibratable Model of Optimal CEO Incentives in Market Equilibrium," NBER Working Papers 13372, National Bureau of Economic Research, Inc.
    3. Hsing-Hua Huang & Chia-Fan Lin, 2014. "The Relationship Between Competition and the Fraction of Firms Using Stock-Based Compensation in an Industry," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 17(01), pages 1-18.
    4. Lustig, Hanno & Syverson, Chad & Van Nieuwerburgh, Stijn, 2011. "Technological change and the growing inequality in managerial compensation," Journal of Financial Economics, Elsevier, vol. 99(3), pages 601-627, March.
    5. Rivolta, Mia L., 2018. "Worth the wait? Delay in CEO succession after unplanned CEO departures," Journal of Corporate Finance, Elsevier, vol. 49(C), pages 225-251.
    6. Alex Edmans & Xavier Gabaix, 2009. "Is CEO Pay Really Inefficient? A Survey of New Optimal Contracting Theories," European Financial Management, European Financial Management Association, vol. 15(3), pages 486-496, June.
    7. Schymik, Jan, 2018. "Globalization and the evolution of corporate governance," European Economic Review, Elsevier, vol. 102(C), pages 39-61.
    8. Schymik, Jan, 2017. "Earnings Inequality and the Global Division of Labor: Evidence from the Executive Labor Market," Discussion Papers in Economics 38385, University of Munich, Department of Economics.

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