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

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Listed author(s):
  • 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.

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

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Date of creation: 01 Sep 1997
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
Web page: http://www.econ.iastate.edu
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Find related papers by 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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  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.
  2. Phelan, C. & Townsend, R.M., 1990. "Computing Multiperiod, Information-Constrained Optima," University of Chicago - Economics Research Center 90-13, Chicago - Economics Research Center.
  3. 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.
  4. Haubrich, Joseph G, 1994. "Risk Aversion, Performance Pay, and the Principal-Agent Problem," Journal of Political Economy, University of Chicago Press, vol. 102(2), pages 258-276, April.
  5. Amal Hili & Didier Laussel & Ngo Van Long, 2016. "Disentangling managerial incentives from a dynamic perspective: the role of stock grants," CIRANO Working Papers 2016s-48, CIRANO.
  6. Cheng Wang, 1995. "Dynamic Insurance with Private Information and Balanced Budgets," Review of Economic Studies, Oxford University Press, vol. 62(4), pages 577-595.
  7. 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.
  8. Andrew Atkeson & Robert E. Lucas, 1992. "On Efficient Distribution With Private Information," Review of Economic Studies, Oxford University Press, vol. 59(3), pages 427-453.
  9. Giorgio Canarella & Mahmoud M. Nourayi, 2008. "Executive compensation and firm performance: adjustment dynamics, non-linearity and asymmetry," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 29(4), pages 293-315.
  10. 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.
  11. repec:emc:wpaper:dte-531 is not listed on IDEAS
  12. Sonia B. Di Giannatale & Itza Curiel & Juan Herrera & Katya Rodriguez, 2010. "Aproximación con algoritmos evolutivos de la frontera de Pareto de un modelo dinámico de agente-principal con acciones discretas," Working papers DTE 476, CIDE, División de Economía.
  13. repec:emc:wpaper:dte-521 is not listed on IDEAS
  14. Desrochers, Martin & Fischer, Klaus P., 2002. "Corporate Governance and Depository Institutions Failure: the Case of an Emerging Market Economy," Cahiers de recherche 0201, CIRPEE.
  15. Jensen, Michael C & Murphy, Kevin J, 1990. "Performance Pay and Top-Management Incentives," Journal of Political Economy, University of Chicago Press, vol. 98(2), pages 225-264, April.
  16. Sonia Di Giannatale & Itza Curiel & Juan Herrera & Katya Rodríguez, 2012. "Productivity Shocks, Discount Rate and Incentives," Working papers DTE 531, CIDE, División de Economía.
  17. Stephen E. Spear & Sanjay Srivastava, 1987. "On Repeated Moral Hazard with Discounting," Review of Economic Studies, Oxford University Press, vol. 54(4), pages 599-617.
  18. Christopher Phelan, 1994. "Incentives and Aggregate Shocks," Review of Economic Studies, Oxford University Press, vol. 61(4), pages 681-700.
  19. Abreu, Dilip & Pearce, David & Stacchetti, Ennio, 1990. "Toward a Theory of Discounted Repeated Games with Imperfect Monitoring," Econometrica, Econometric Society, vol. 58(5), pages 1041-1063, September.
  20. 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.
  21. 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.
  22. Phelan Christopher, 1995. "Repeated Moral Hazard and One-Sided Commitment," Journal of Economic Theory, Elsevier, vol. 66(2), pages 488-506, August.
  23. Jarque, Arantxa & John, Muth, 2013. "Evaluating Executive Compensation Packages," Economic Quarterly, Federal Reserve Bank of Richmond, issue 4Q, pages 251-285.
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