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A Calibratable Model of Optimal CEO Incentives in Market Equilibrium

  • Alex Edmans
  • Xavier Gabaix
  • Augustin Landier

This paper presents a unified framework for understanding the determinants of both CEO incentives and total pay levels in competitive market equilibrium. It embeds a modified principal-agent problem into a talent assignment model to endogenize both elements of compensation. The model's closed form solutions yield testable predictions for how incentives should vary across firms under optimal contracting. In particular, our calibrations show that the negative relationship between the CEO's effective equity stake and firm size is quantitatively consistent with efficiency and need not reflect rent extraction. Our model and data both also imply that the dollar change in wealth for a percentage change in firm value, scaled by annual pay, is independent of firm size. This may render it an attractive incentive measure as it is comparable between firms and over time. The theory also predicts a positive relationship between pay volatility and firm volatility, and that risk and effort affect total pay along the cross-section but not in the aggregate. Finally, we demonstrate that incentive compensation is effective at solving large agency problems, such as selecting corporate strategy, but smaller issues such as perk consumption are best addressed through direct monitoring.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13372.

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Date of creation: Sep 2007
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Handle: RePEc:nbr:nberwo:13372
Note: CF EFG
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