Dynamic Managerial Compensation: a Mechanism Design Approach
We characterize the optimal incentive scheme for a manager who faces costly effort decisions and whose ability to generate profits for the firm varies stochastically over time. The optimal contract is obtained as the solution to a dynamic mechanism design problem with hidden actions and persistent shocks to the agent’s productivity. When the agent is risk-neutral, the optimal contract can often be implemented with a simple pay package that is linear in the firm’s profits. Furthermore, the power of the incentive scheme typically increases over time, thus providing a possible justification for the frequent practice of putting more stocks and options in the package of managers with a longer tenure in the rm. In contrast to other explanations proposed in the literature (e.g., declining disutility of effort or career concerns), the optimality of seniority-based reward schemes is not driven by variations in the agent’s preferences or in his outside option. It results from an optimal allocation of the manager’s informational rents over time. Building on the insights from the risk-neutral case, we then explore the properties of optimal incentive schemes for risk-averse managers. We find that, other things equal, risk-aversion reduces the benefit of inducing higher effort over time. Whether (risk-averse) managers with a longer tenure receive more or less high-powered incentives than younger ones then depends on the interaction between the degree of risk aversion and the dynamics of the impulse responses for the shocks to the manager's type.
|Date of creation:||01 Sep 2009|
|Date of revision:|
|Contact details of provider:|| Postal: Center for Mathematical Studies in Economics and Management Science, Northwestern University, 580 Jacobs Center, 2001 Sheridan Road, Evanston, IL 60208-2014|
Web page: http://www.kellogg.northwestern.edu/research/math/
More information through EDIRC
|Order Information:|| Email: |
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Milgrom, Paul & Shannon, Chris, 1994.
"Monotone Comparative Statics,"
Econometric Society, vol. 62(1), pages 157-80, January.
- Marco Battaglini, 2003.
"Long-Term Contracting with Markovian Consumers,"
Theory workshop papers
505798000000000048, UCLA Department of Economics.
- Peter M. DeMarzo & Michael J. Fishman, 2007. "Optimal Long-Term Financial Contracting," Review of Financial Studies, Society for Financial Studies, vol. 20(6), pages 2079-2128, November.
- 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.
- Battaglini, Marco & Coate, Stephen, 2008.
"Pareto efficient income taxation with stochastic abilities,"
Journal of Public Economics,
Elsevier, vol. 92(3-4), pages 844-868, April.
- Stephen Coate & Marco Battaglini, 2004. "Pareto Efficient Income Taxation with Stochastic Abilities," 2004 Meeting Papers 140, Society for Economic Dynamics.
- Marco Battaglini & Stephen Coate, 2003. "Pareto Efficient Income Taxation with Stochastic Abilities," NBER Working Papers 10119, National Bureau of Economic Research, Inc.
- Alessandro Pavan & Ilya Segal & Juuso Toikka, 2008.
"Dynamic Mechanism Design: Incentive Compatibility, Profit Maximization and Information Disclosure,"
Carlo Alberto Notebooks
84, Collegio Carlo Alberto.
- Alessandro Pavan & Ilya Segal & Juuso Toikka, 2009. "Dynamic Mechanism Design: Incentive Compatibility, Profit Maximization and Information Disclosure," Discussion Papers 1501, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
- Phelan, C. & Townsend, R.M., 1990.
"Computing Multiperiod, Information-Constrained Optima,"
University of Chicago - Economics Research Center
90-13, Chicago - Economics Research Center.
- Christopher Phelan & Robert M Townsend, 2010. "Computing Multi-Period, Information Constrained Optima," Levine's Working Paper Archive 117, David K. Levine.
- Stefania Albanesi & Christopher Sleet, 2004.
"Dynamic optimal taxation with private information,"
Discussion Paper / Institute for Empirical Macroeconomics
140, Federal Reserve Bank of Minneapolis.
- Mathias Dewatripont & Ian Jewitt & Jean Tirole, 1999.
"The economics of career concerns: part 1 :comparing information structures,"
ULB Institutional Repository
2013/9617, ULB -- Universite Libre de Bruxelles.
- Mathias Dewatripont & Ian Jewitt & Jean Tirole, 1999. "The Economics of Career Concerns, Part I: Comparing Information Structures," Review of Economic Studies, Oxford University Press, vol. 66(1), pages 183-198.
- Gibbons, R. & Murphy, K.J., 1990.
"Optimal Incentive Contracts In The Presence Of Career Concerns: Theory And Evidence,"
563, Massachusetts Institute of Technology (MIT), Department of Economics.
- Gibbons, Robert & Murphy, Kevin J, 1992. "Optimal Incentive Contracts in the Presence of Career Concerns: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 100(3), pages 468-505, June.
- Murphy, K.J. & Gibbons, R., 1990. "Optimal Incentive Contracts in the Presence of Career Concerns : Theory and Evidence," Papers 90-09, Rochester, Business - Managerial Economics Research Center.
- Robert Gibbons & Kevin J. Murphy, 1991. "Optimal Incentive Contracts in the Presence of Career Concerns: Theory and Evidence," NBER Working Papers 3792, National Bureau of Economic Research, Inc.
- Zhang, Yuzhe, 2009.
"Dynamic Contracting with Persistent Shocks,"
23108, University Library of Munich, Germany.
- Jean-Jacques Laffont & Jean Tirole, 1990. "Adverse Selection and Renegotiation in Procurement," Review of Economic Studies, Oxford University Press, vol. 57(4), pages 597-625.
- PETER M. DeMARZO & YULIY SANNIKOV, 2006. "Optimal Security Design and Dynamic Capital Structure in a Continuous-Time Agency Model," Journal of Finance, American Finance Association, vol. 61(6), pages 2681-2724, December.
When requesting a correction, please mention this item's handle: RePEc:nwu:cmsems:1491. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Fran Walker)
If references are entirely missing, you can add them using this form.