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Optimal CEO Incentives and Industry Dynamics

  • Dalida Kadyrzhanova

    (University of Maryland)

  • Antonio Falato

    (Federal Reserve Board)

This paper develops a competitive equilibrium model of CEO compensation and industry dynamics. CEOs make product pricing and product improvement decisions subject to shareholders'’ compensation choices and idiosyncratic shocks to product quality. The choice of high-powered incentives optimally trades-off the benefits from expected product improvements and the associated agency costs. In market equilibrium, the interaction between CEO pay and product market decisions affects the stationary distribution of firms. We characterize a dynamic feedback effect of industry structure on CEO incentives. As a result of this effect, we predict an inverse relation between the magnitude of the performance-based component of CEO pay and, (i) across industries, the degree of heterogeneity of industry structure; (ii) within industries, firm position with respect to its peers. We empirically estimate pay-performance sensitivity for a large sample of U.S. CEOs and other top executives over the 1993 to 2004 period and find strong support for our theory. Our results offer a novel product market rationale for the increased reliance of CEO pay on bonuses and stock options over the 1990s.

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Paper provided by Society for Economic Dynamics in its series 2008 Meeting Papers with number 880.

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Date of creation: 2008
Date of revision:
Handle: RePEc:red:sed008:880
Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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