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Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts

  • John B. Donaldson
  • Natalia Gershun
  • Marc P. Giannoni

We consider a simple variant of the standard real business cycle model in which shareholders hire a self-interested executive to manage the firm on their behalf. Delegation gives rise to a generic conflict of interest mediated by a convex (option-like) compensation contract which is able to align the interests of managers and their shareholders. With such a compensation contract, a given increase in the firm's output generated by an additional unit of physical investment results in a more than proportional increase in the manager's income. We find that incentive contracts of this form can easily result in an indeterminate general equilibrium, with business cycles driven by self-fulfilling fluctuations in the manager's expectations. These expectations are unrelated to fundamentals. Arbitrarily large fluctuations in macroeconomic variables may possibly result.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15165.

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Date of creation: Jul 2009
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Publication status: published as Donaldson, John B. & Gershun, Natalia & Giannoni, Marc P., 2013. "Some unpleasant general equilibrium implications of executive incentive compensation contracts," Journal of Economic Theory, Elsevier, vol. 148(1), pages 31-63.
Handle: RePEc:nbr:nberwo:15165
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