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 fim 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 private information. 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 firm. Contrary to other explanations proposed in the literature (e.g. declining disutility of effort, learning by doing, career concerns), the optimality of seniority-based reward schemes is not driven by any particular assumption on the agent's preferences/technology. 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. Contrary to the risk-neutral case, the optimal pay package is typically non-linear in the firm's profits (although, there are instances where it is convex function of a linear aggregator). Furthermore, we find that risk-aversion may reduce (but not necessarily eliminate) the benefit of offering incentives whose power increase, on average, over time.
|Date of creation:||2009|
|Contact details of provider:|| Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA|
Web page: http://www.EconomicDynamics.org/
More information through EDIRC
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.:
- Christopher Phelan & Robert M Townsend, 2010.
"Computing Multi-Period, Information Constrained Optima,"
Levine's Working Paper Archive
117, David K. Levine.
- Phelan, C. & Townsend, R.M., 1990. "Computing Multiperiod, Information-Constrained Optima," University of Chicago - Economics Research Center 90-13, Chicago - Economics Research Center.
- Zhang, Yuzhe, 2009.
"Dynamic contracting with persistent shocks,"
Journal of Economic Theory,
Elsevier, vol. 144(2), pages 635-675, March.
- Stephen Coate & Marco Battaglini, 2004.
"Pareto Efficient Income Taxation with Stochastic Abilities,"
2004 Meeting Papers
140, Society for Economic Dynamics.
- 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.
- Marco Battaglini & Stephen Coate, 2003. "Pareto Efficient Income Taxation with Stochastic Abilities," NBER Working Papers 10119, National Bureau of Economic Research, Inc.
- 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.
- 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.
- 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.
- Gibbons, R. & Murphy, K.J., 1990. "Optimal Incentive Contracts In The Presence Of Career Concerns: Theory And Evidence," Working papers 563, Massachusetts Institute of Technology (MIT), Department of Economics.
- Besanko, David, 1985. "Multi-period contracts between principal and agent with adverse selection," Economics Letters, Elsevier, vol. 17(1-2), pages 33-37.
- Milgrom, P. & Shannon, C., 1991.
"Monotone Comparative Statics,"
11, Stanford - Institute for Thoretical Economics.
- Holmstrom, Bengt & Milgrom, Paul, 1987.
"Aggregation and Linearity in the Provision of Intertemporal Incentives,"
Econometric Society, vol. 55(2), pages 303-28, March.
- Bengt Holmstrom & Paul R. Milgrom, 1985. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Cowles Foundation Discussion Papers 742, Cowles Foundation for Research in Economics, Yale University.
- 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.
- 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.
- Baron, David P. & Besanko, David, 1984. "Regulation and information in a continuing relationship," Information Economics and Policy, Elsevier, vol. 1(3), pages 267-302.
- Albanesi, Stefania & Sleet, Christopher, 2003.
"Dynamic Optimal Taxation with Private Information,"
CEPR Discussion Papers
4006, C.E.P.R. Discussion Papers.
- Stefania Albanesi & Christopher Sleet, 2004. "Dynamic optimal taxation with private information," Discussion Paper / Institute for Empirical Macroeconomics 140, Federal Reserve Bank of Minneapolis.
- Lippert, Robert L. & Porter, Gayle, 1997. "Understanding CEO pay: A test of two pay-to-performance sensitivity measures with alternative measures of alignment and influence," Journal of Business Research, Elsevier, vol. 40(2), pages 127-138, October.
- 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.
- 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.
- 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.
- Marco Battaglini, 2005.
"Long-Term Contracting with Markovian Consumers,"
American Economic Review,
American Economic Association, vol. 95(3), pages 637-658, June.
- 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.
- Laffont, Jean-Jacques & Tirole, Jean, 1986.
"Using Cost Observation to Regulate Firms,"
Journal of Political Economy,
University of Chicago Press, vol. 94(3), pages 614-641, June.
When requesting a correction, please mention this item's handle: RePEc:red:sed009:375. 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: (Christian Zimmermann)
If references are entirely missing, you can add them using this form.