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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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