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Paying to Make a Difference: Executive Compensation and Product Dynamics

Author

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  • Antonio Falato

    () (Finance HEC Montréal)

Abstract

This paper develops an agency model of executive compensation in dynamic industry equilibrium. Firms differ in the quality of their products, and managers can make a difference as higher effort brings about product improvement. I show that there is an inverse relationship between the magnitude of the performance-based component of optimal compensation contracts and the degree of product differentiation, as managerial effort is less likely to make a difference for firms with more differentiated products. Empirically, I find strong evidence of this inverse relation in the compensation of US executives. In particular, I find that pay-performance sensitivity depends negatively on industry- and firm-level measures of product differentiation, even after controlling for industry fixed effects and standard measures of product market competition. Moreover, industry leaders have weaker pay-performance sensitivity than laggards, even after controlling for firm size. My findings suggest that industry is an important determinant of executive compensation

Suggested Citation

  • Antonio Falato, 2006. "Paying to Make a Difference: Executive Compensation and Product Dynamics," 2006 Meeting Papers 690, Society for Economic Dynamics.
  • Handle: RePEc:red:sed006:690
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    References listed on IDEAS

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    More about this item

    Keywords

    Incentives; Optimal Contracts; Executive Compensation; Industry Dynamics;

    JEL classification:

    • G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance

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