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Output-based Pay: Incentives or Sorting?

  • Edward P. Lazear

Variable pay, defined as pay that is tied to some measure of a firm's output, has become more important for executives of the typical American firm. Variable pay is usually touted as a way to provide incentives to managers whose interests may not be perfectly aligned with those of owners. The incentive justification for variable pay has well-known theoretical problems and also appears to be inconsistent with much of the data. Alternative explanations are considered. One that has not received much attention, but that is consistent with may of the facts, is selection. Managers and industry specialists may have information about a firm's prospects that is unavailable to outside investors. In order to induce managers to be truthful about prospects, owners may require managers to 'put their money where their mouths are,' forcing them to extract some of their compensation in the form of variable pay. The selection or sorting explanation is consistent with the low elasticities of pay to output that are commonly observed, with the fact that the elasticity is higher in small and new firms, and with the fact that variable pay is more prevalent in industries with very technical production technologies. It does not explain why some firms give stock options even to very low-level workers.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7419.

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Date of creation: Nov 1999
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Handle: RePEc:nbr:nberwo:7419
Note: LS
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  1. Kandel, E. & Lazear, E.P., 1990. "Peer Pressure and Partnerships," Papers 90-07, Rochester, Business - Managerial Economics Research Center.
  2. Edward P. Lazear, 1995. "Personnel Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262121883, June.
  3. Joseph G. Haubrich, 1991. "Risk aversion, performance pay, and the principal-agent problem," Working Paper 9118, Federal Reserve Bank of Cleveland.
  4. Myerson, Roger B, 1983. "Mechanism Design by an Informed Principal," Econometrica, Econometric Society, vol. 51(6), pages 1767-97, November.
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  6. Murphy, Kevin J., 1999. "Executive compensation," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 38, pages 2485-2563 Elsevier.
  7. Brian J. Hall & Jeffrey B. Liebman, 1998. "Are CEOs Really Paid Like Bureaucrats?," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 653-691, August.
  8. Paarsch, Harry J. & Shearer, Bruce, 1997. "Fixed Wages, Piece Rates, and Intertemporal Productivity: a Study of tree Planters in British Columbia," Cahiers de recherche 9702, Université Laval - Département d'économique.
  9. Edward P. Lazear, 1999. "Personnel Economics: Past Lessons and Future Directions," NBER Working Papers 6957, National Bureau of Economic Research, Inc.
  10. Yermack, David, 1995. "Do corporations award CEO stock options effectively?," Journal of Financial Economics, Elsevier, vol. 39(2-3), pages 237-269.
  11. George P. Baker & Brian J. Hall, 1998. "CEO Incentives and Firm Size," NBER Working Papers 6868, National Bureau of Economic Research, Inc.
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  13. Groves, Theodore, 1973. "Incentives in Teams," Econometrica, Econometric Society, vol. 41(4), pages 617-31, July.
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  15. Jensen, M.C. & Murphy, K.J., 1988. "Performance Pay And Top Management Incentives," Papers 88-04, Rochester, Business - Managerial Economics Research Center.
  16. Richard B. Freeman & Morris M. Kleiner, 1998. "The Last American Shoe Manufacturers: Changing the Method of Pay to Survive Foreign Competition," NBER Working Papers 6750, National Bureau of Economic Research, Inc.
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