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When to Fire a CEO: Optimal Termination in Dynamic Contracts

  • Spear, Stephen E.
  • Wang, Cheng

Existing models of dynamic contracts impose that it is both optimal and feasible for the contracting parties to bind themselves together forever. This paper introduces optimal terminatin in dynamic contracts. We modify the standard dynamic agency model to include an external labor market which, upon the dissolution of the contract, allows the firm to return to the labor market to seek a new match. Under this simple closure of the model, two types of terminations emerge. Under one scenario, the agent is fired after a sequence of bad outputs and she becomes too poor to be punished effectively. Under the second scenario, the agent is forced out after a sequence of good outputs and she becomes too expensive to motivate. We then use the model to study issues of CEO termination and firm dynamics.

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Paper provided by Iowa State University, Department of Economics in its series Staff General Research Papers with number 11443.

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Date of creation: 01 Jan 2005
Date of revision:
Publication status: Published in Journal of Economic Theory 2005, vol. 120, pp. 239-256
Handle: RePEc:isu:genres:11443
Contact details of provider: Postal: Iowa State University, Dept. of Economics, 260 Heady Hall, Ames, IA 50011-1070
Phone: +1 515.294.6741
Fax: +1 515.294.0221
Web page: http://www.econ.iastate.edu
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  1. Phelan Christopher, 1995. "Repeated Moral Hazard and One-Sided Commitment," Journal of Economic Theory, Elsevier, vol. 66(2), pages 488-506, August.
  2. Wang, Cheng, 1997. "Incentives, CEO Compensation and Shareholder Wealth in a Dynamic Agency Model," Staff General Research Papers 5170, Iowa State University, Department of Economics.
  3. Shapiro, Carl & Stiglitz, Joseph E, 1984. "Equilibrium Unemployment as a Worker Discipline Device," American Economic Review, American Economic Association, vol. 74(3), pages 433-44, June.
  4. Stiglitz, Joseph E & Weiss, Andrew, 1983. "Incentive Effects of Terminations: Applications to the Credit and Labor Markets," American Economic Review, American Economic Association, vol. 73(5), pages 912-27, December.
  5. Spear, Stephen E & Srivastava, Sanjay, 1987. "On Repeated Moral Hazard with Discounting," Review of Economic Studies, Wiley Blackwell, vol. 54(4), pages 599-617, October.
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