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Incentives, CEO Compensation and Shareholder Wealth in a Dynamic Agency Model

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  • Wang, Cheng

Abstract

M. Jensen and K. Murphy (1990,J. Polit. Econ.98, 225-264) argue that the observed pay-performance sensitivity of CEO compensation is too low to be consistent with formal agency theory. This paper uses a dynamic agency model to offer a resolution of the Jensen and Murphy puzzle. We show that the dynamic agency model can predict either a positive or a negative pay-performance sensitivity, depending on the parameter values of the model and the distribution of the CEOs' initial expected discounted utilities. For a large variety of parameter values and for properly chosen distributions of initial CEO expected discounted utilities, our model is capable of generating data where the pay-performance sensitivity is significantly positive but very small, as in Jensen and Murphy's data. The key to our result is a compensation rigidity that is created endogenously by the optimal dynamic contract.Journal of Economic LiteratureClassification Numbers: C63, D82, G30. *1 This paper was motivated by a conversation with Narayana Kocherlakota to whom I am also indebted for his advice. I thank Steve Williamson for his guidance and support. I thank the associate editor and three anonymous referees for their useful comments and suggestions. I am also grateful to Dean Corbae, Ed Green, Andreas Hornstein, Peter Howitt, Arthur Robson, Steve Spear, and seminar participants at the Universities of Iowa, Western Ontario, Rochester, Queen's, Chicago, Federal Reserve Bank of Richmond, Iowa State, Toronto, Simon Fraser, Carnegie-Mellon, and Illinois for discussions and comments. Financial support from the Social Science and Humanities Research Council of Canada is acknowledged. *2 E. PrescottN. Wallace, Eds.

Suggested Citation

  • Wang, Cheng, 1997. "Incentives, CEO Compensation and Shareholder Wealth in a Dynamic Agency Model," Staff General Research Papers Archive 5170, Iowa State University, Department of Economics.
    • Handle: RePEc:isu:genres:5170
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    References listed on IDEAS

    as
    1. Sonia Di Giannatale & Itza T. Q. Curiel & Juan A. Herrera & Katya Rodríguez, 2011. "Risk Aversion and the Pareto Frontier of a Dynamic Principal-Agent Model: An Evolutionary Approximation," Working papers DTE 521, CIDE, División de Economía.
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    7. Amal Hili & Didier Laussel & Ngo Van Long, 2017. "Disentangling managerial incentives from a dynamic perspective: The role of stock grants," Pacific Economic Review, Wiley Blackwell, vol. 22(5), pages 743-771, December.
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    26. Itza Curiel & Sonia Di Giannatale & Juan Herrera & Katya Rodríguez, 2012. "Pareto Frontier of a Dynamic Principal–Agent Model with Discrete Actions: An Evolutionary Multi-Objective Approach," Computational Economics, Springer;Society for Computational Economics, vol. 40(4), pages 415-443, December.
    27. Garen, John E, 1994. "Executive Compensation and Principal-Agent Theory," Journal of Political Economy, University of Chicago Press, vol. 102(6), pages 1175-1199, December.
    28. Arantxa Jarque, 2014. "The Complexity of CEO Compensation: Incentives and Learning," 2014 Meeting Papers 1355, Society for Economic Dynamics.
    29. Guy Kaplanski & Haim Levy, 2012. "Executive Short-Term Incentive, Risk-Taking And Leverage-Neutral Incentive Scheme," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 7(01), pages 1-45.
    30. Arantxa Jarque, 2014. "The Complexity of CEO Compensation," Working Paper 14-16, Federal Reserve Bank of Richmond, revised 02 Oct 2014.
    31. Chaigneau, Pierre, 2018. "The optimal timing of CEO compensation," Finance Research Letters, Elsevier, vol. 24(C), pages 90-94.
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    33. Arantxa Jarque & Muth John, 2013. "Evaluating Executive Compensation Packages," Economic Quarterly, Federal Reserve Bank of Richmond, issue 4Q, pages 251-285.
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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. Gian Luca Clementi & Thomas Cooley, 2009. "Executive Compensation: Facts," Working Papers 09-16, New York University, Leonard N. Stern School of Business, Department of Economics.
    3. Giat, Yahel & Subramanian, Ajay, 2013. "Dynamic contracting under imperfect public information and asymmetric beliefs," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2833-2861.
    4. Hugo Hopenhayn & Arantxa Jarque, 2006. "Moral Hazard and Persistence," 2006 Meeting Papers 670, Society for Economic Dynamics.
    5. Emilio Espino & Juan M. Sanchez, 2010. "Risk sharing, investment, and incentives in the neoclassical growth model," Economic Quarterly, Federal Reserve Bank of Richmond, vol. 96(4Q), pages 399-416.
    6. Wang, Cheng, 2011. "Termination of dynamic contracts in an equilibrium labor market model," Journal of Economic Theory, Elsevier, vol. 146(1), pages 74-110, January.
    7. Vincenzo Quadrini & Ramon Marimon & Thomas Cooley, 2012. "Risky Investments with Limited Commitment," 2012 Meeting Papers 603, Society for Economic Dynamics.
    8. Amal Hili & Didier Laussel & Ngo Van Long, 2017. "Disentangling managerial incentives from a dynamic perspective: The role of stock grants," Pacific Economic Review, Wiley Blackwell, vol. 22(5), pages 743-771, December.
    9. Arantxa Jarque, 2010. "Hidden effort, learning by doing, and wage dynamics," Economic Quarterly, Federal Reserve Bank of Richmond, vol. 96(4Q), pages 339-372.
    10. Spear, Stephen E. & Wang, Cheng, 2005. "When to fire a CEO: optimal termination in dynamic contracts," Journal of Economic Theory, Elsevier, vol. 120(2), pages 239-256, February.
    11. Jorge Aseff & Manuel Santos, 2005. "Stock options and managerial optimal contracts," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 26(4), pages 813-837, November.
    12. 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.
    13. Sonia Di Giannatale Menegalli & Itza T. Q. Curiel-Cabral, 2013. "Compromises and Incentives," Working papers DTE 559, CIDE, División de Economía.
    14. Stefania Albanesi & Claudia Olivetti & María José Prados, 2015. "Gender and Dynamic Agency: Theory and Evidence on the Compensation of Top Executives," Research in Labor Economics, in: Solomon W. Polachek & Konstantinos Tatsiramos & Klaus F. Zimmermann (ed.),Gender in the Labor Market, volume 42, pages 1-59, Emerald Publishing Ltd.
    15. Bond, Philip & Newman, Andrew F., 2009. "Prohibitions on punishments in private contracts," Journal of Financial Intermediation, Elsevier, vol. 18(4), pages 526-540, October.
    16. Stefania Albanesi & Claudia Olivetti, 2006. "Gender and Dynamic Agency: Theory and Evidence on the Compensation of Female Top Executives," Boston University - Department of Economics - Working Papers Series WP2006-061, Boston University - Department of Economics.
    17. Itza Curiel & Sonia Di Giannatale & Juan Herrera & Katya Rodríguez, 2012. "Pareto Frontier of a Dynamic Principal–Agent Model with Discrete Actions: An Evolutionary Multi-Objective Approach," Computational Economics, Springer;Society for Computational Economics, vol. 40(4), pages 415-443, December.
    18. Chaigneau, Pierre, 2018. "The optimal timing of CEO compensation," Finance Research Letters, Elsevier, vol. 24(C), pages 90-94.
    19. Arantxa Jarque, 2008. "Optimal CEO compensation and stock options," Working Papers. Serie EC 2008-04, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
    20. Pierre Chaigneau, 2010. "The Optimal Timing of Executive Compensation," FMG Discussion Papers dp660, Financial Markets Group.
    21. Arantxa Jarque, 2008. "CEO compensation : trends, market changes, and regulation," Economic Quarterly, Federal Reserve Bank of Richmond, vol. 94(Sum), pages 265-300.
    22. Quadrini, Vincenzo, 2004. "Investment and liquidation in renegotiation-proof contracts with moral hazard," Journal of Monetary Economics, Elsevier, vol. 51(4), pages 713-751, May.
    23. Arantxa Jarque, 2014. "The Complexity of CEO Compensation," Working Paper 14-16, Federal Reserve Bank of Richmond, revised 02 Oct 2014.
    24. Arantxa Jarque & Muth John, 2013. "Evaluating Executive Compensation Packages," Economic Quarterly, Federal Reserve Bank of Richmond, issue 4Q, pages 251-285.

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    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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