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Paying to Make a Difference: Executive Compensation and Product Dynamics

  • Antonio Falato


    (Finance HEC Montréal)

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

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Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 690.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:690
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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