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

  • Wang, Cheng

M. Jensen and K. Murphy (1990,J. Polit. Econ.98, 225ï¾–264) argue that the observed payï¾–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 payï¾–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 payï¾–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.

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Paper provided by Iowa State University, Department of Economics in its series Staff General Research Papers with number 5170.

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Date of creation: 01 Sep 1997
Date of revision:
Publication status: Published in Journal of Economic Theory, September 1997, vol. 76 no. 1, pp. 72-105
Handle: RePEc:isu:genres:5170
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
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  1. Phelan, Christopher, 1994. "Incentives and Aggregate Shocks," Review of Economic Studies, Wiley Blackwell, vol. 61(4), pages 681-700, October.
  2. Jensen, M.C. & Murphy, K.J., 1988. "Performance Pay And Top Management Incentives," Papers 88-04, Rochester, Business - Managerial Economics Research Center.
  3. Atkeson, Andrew & Lucas, Robert E, Jr, 1992. "On Efficient Distribution with Private Information," Review of Economic Studies, Wiley Blackwell, vol. 59(3), pages 427-53, July.
  4. Joseph G. Haubrich, 1991. "Risk aversion, performance pay, and the principal-agent problem," Working Paper 9118, Federal Reserve Bank of Cleveland.
  5. Dilip Abreu & David Pearce & Ennio Stacchetti, 2010. "Towards a Theory of Discounted Repeated Games with Imperfect Monitoring," Levine's Working Paper Archive 199, David K. Levine.
  6. Phelan, C. & Townsend, R.M., 1990. "Computing Multiperiod, Information-Constrained Optima," University of Chicago - Economics Research Center 90-13, Chicago - Economics Research Center.
  7. 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.
  8. Wang, Cheng, 1995. "Dynamic Insurance with Private Information and Balanced Budgets," Staff General Research Papers 5249, Iowa State University, Department of Economics.
  9. Garen, John E, 1994. "Executive Compensation and Principal-Agent Theory," Journal of Political Economy, University of Chicago Press, vol. 102(6), pages 1175-99, December.
  10. Phelan Christopher, 1995. "Repeated Moral Hazard and One-Sided Commitment," Journal of Economic Theory, Elsevier, vol. 66(2), pages 488-506, August.
  11. Abreu, Dilip & Pearce, David & Stacchetti, Ennio, 1990. "Toward a Theory of Discounted Repeated Games with Imperfect Monitoring," Econometrica, Econometric Society, vol. 58(5), pages 1041-63, September.
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