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Pay-for-Luck in CEO Compensation: Matching and Efficient Contracting

Author

Listed:
  • Pierre Chaigneau
  • Nicolas Sahuguet

Abstract

We develop a stylized model of efficient contracting with matching between firms and managers with state-contingent reservation utility. We show that the optimal contract is designed to retain and insure the manager. The retention motive explains pay-for-luck in executive compensation, while the insurance feature explains asymmetric pay-for-luck. This contract can be implemented with call options based on a single performance measure which generally does not filter out luck. When costs of involuntary managerial turnover differ across firms, and the abilities of different managers are more or less precisely estimated ex-ante, the model can also explain the observed association between pay-for-luck and bad corporate governance.

Suggested Citation

  • Pierre Chaigneau & Nicolas Sahuguet, 2012. "Pay-for-Luck in CEO Compensation: Matching and Efficient Contracting," Cahiers de recherche 1224, CIRPEE.
  • Handle: RePEc:lvl:lacicr:1224
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    File URL: http://www.cirpee.org/fileadmin/documents/Cahiers_2012/CIRPEE12-24.pdf
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    References listed on IDEAS

    as
    1. Xavier Gabaix & Augustin Landier, 2008. "Why has CEO Pay Increased So Much?," The Quarterly Journal of Economics, Oxford University Press, vol. 123(1), pages 49-100.
    2. Patrick Legros & Andrew F. Newman, 2007. "Beauty Is a Beast, Frog Is a Prince: Assortative Matching with Nontransferabilities," Econometrica, Econometric Society, vol. 75(4), pages 1073-1102, July.
    3. Maug, Ernst & Dittmann, Ingolf, 2007. "Lower salaries and no options : the optimal structure of executive pay
      [Lower salaries and no options? On the optimal structure of executive pay]
      ," Papers 07-41, Sonderforschungsbreich 504.
    4. Ingolf Dittmann & Ernst Maug & Oliver Spalt, 2010. "Sticks or Carrots? Optimal CEO Compensation when Managers Are Loss Averse," Journal of Finance, American Finance Association, vol. 65(6), pages 2015-2050, December.
    5. Fabio Feriozzi, 2011. "Paying for observable luck," RAND Journal of Economics, RAND Corporation, vol. 42(2), pages 387-415, June.
    6. Jonathan Thomas & Tim Worrall, 1988. "Self-Enforcing Wage Contracts," Review of Economic Studies, Oxford University Press, vol. 55(4), pages 541-554.
    7. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
    8. Marianne Bertrand & Sendhil Mullainathan, 2001. "Are CEOs Rewarded for Luck? The Ones Without Principals Are," The Quarterly Journal of Economics, Oxford University Press, vol. 116(3), pages 901-932.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    CEO pay; corporate governance; pay-for-luck; stock-options;

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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