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Journal ArticleDOI

Managerial Expertise, Private Information, and Pay-Performance Sensitivity

01 Mar 2008-Management Science (INFORMS)-Vol. 54, Iss: 3, pp 429-442

TL;DR: This paper characterizes optimal pay-performance sensitivities of compensation contracts for managers who have private information about their skills, and those skills affect their outside employment opportunities, and identifies plausible circumstances under which risk and incentives are positively associated.

AbstractThis paper characterizes optimal pay-performance sensitivities of compensation contracts for managers who have private information about their skills, and those skills affect their outside employment opportunities. The model presumes that the rate at which a manager's opportunity wage increases in his expertise depends on the nature of that expertise, i.e., whether it is general or firm specific. The analysis demonstrates that when managerial expertise is largely firm specific (general), the optimal pay-performance sensitivity is lower (higher) than its optimal value in a benchmark setting of symmetric information. Furthermore, when managerial skills are largely firm specific (general), the optimal pay-performance sensitivity decreases (increases) as managerial skills become a more important determinant of firm performance. Unlike the standard agency-theoretic prediction of a negative trade-off between risk and pay-performance sensitivity, this paper identifies plausible circumstances under which risk and incentives are positively associated. In addition to providing an explanation for why empirical tests of risk-incentive relationships have produced mixed results, the analysis generates insights that can be useful in guiding future empirical research.

Topics: Skills management (56%), Empirical research (51%)

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Citations
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Posted Content
Abstract: This study focuses on the relation between current compensation and past performance measures as signals of a CEO’s ability. We develop a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993-2006. Consistent with the predictions, we find that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly-hired CEOs. We also find that while current salary is positively associated with future performance, current bonus is not. As the model suggests, salary is adjusted to meet the reservation utility and information rent, and is positively correlated over time to reflect ability. Bonus serves to address moral hazard and adverse selection by separating high-ability agents into riskier contracts. Our results indicate that it is important to disaggregate cash compensation into salary and bonus components to understand the dynamic interaction between incentives and performance.

94 citations


Cites background from "Managerial Expertise, Private Infor..."

  • ...(A.9) We infer that the coefficient )( 00 aβ belongs to a direct revelation mechanism if it is increasing in Period 0 ability (i.e., 0) ≥( 00′ aβ ), in agreement with Salanie (2005, p. 31) and Dutta (2008)....

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  • ...21 2 1001 2 1100111001110011 2 ccRayaaayadzayzraya a a σδββλβλα −−−+= ∫ 9 This is a common assumption in mechanism design (Bolton and Dewatripont 2005; Salanie 2005; Dutta 2008)....

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  • ...Second, the agent’s ability could be multidimensional (McAfee et al. 1989; Dutta 2008)....

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  • ...As in Dutta (2008), Datar et al. (2001), Holmstrom and Milgrom (1987), and Feltham and Xie (1994), we also assume the agent has constant absolute risk aversion (utility) with a coefficient of absolute risk aversion (CARA) of R such that his Period 0 utility is: ]}2/)())),((,([exp{))()),),((,(( 0 2…...

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Journal ArticleDOI
Abstract: This study focuses on the relation between current compensation and past performance measures as signals of a chief executive officer's (CEO's) ability. We develop a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993–2006. Consistent with the predictions, we find that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly hired CEOs. We also find that while current salary is positively associated with future performance, current bonus is not. As the model suggests, salary is adjusted to meet the reservation utility and information rent, and is positively correlated over time to reflect ability. Bonus serves to address moral hazard and adverse selection by separating high-ability agents into riskier contracts. Our results indicate that it is important to disaggregate cash compensation into salary and bonus components to understand the dynamic intera...

78 citations


Journal ArticleDOI
Abstract: Based on the talent management literature, this paper investigates managerial skills that are essential for managers’ job promotion. Using arguments from the human and social capital literature and following tournament logic, we claim that a manager’s own experience, expertise, and network size positively affect promotion odds, while strong colleagues decrease promotion odds. Studying 7,003 promotions to middle management and 3,147 promotions to senior management, we find broad support for our hypotheses, but find also that network size no longer predicts promotion to senior management. Our findings have implications for individual career development and talent management programs.

61 citations


Cites background from "Managerial Expertise, Private Infor..."

  • ...We distinguish between managers’ experience (e.g., Schmidt, Hunter, & Outerbridge, 1986) – defined as their work tenure (Fisher & Govindarajan, 1992) – and managers’ expertise (e.g., Dutta, 2008) – defined as their focus in a specific work domain....

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Posted Content
Abstract: Building on archival, anecdotal, and survey evidence on managers' roles in accounting manipulations, I develop an agency model to examine the effects of a CEO's power to pressure a CFO to bias a performance measure, like earnings. This power has implications for incentive compensation, reporting quality, firm value, and information rents. Predictions from the model provide potential explanations for the differing results from recent empirical studies on the impact of regulatory interventions like SOX and the extent to which the CEO's or CFO's incentives significantly impact on earnings management. The model also identifies conditions under which either a powerful or a non-powerful CEO can extract rents, which can help explain mixed empirical results on the association between CEO power and "excessive" compensation.

59 citations


Additional excerpts

  • ...Similar to this paper, Dutta (2008) features countervailing incentives in a LEN model with adverse selection, but in Dutta (2008), countervailing incentives are driven by the correlation between a productive agent s productivity and her outside option or reservation wage....

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Journal ArticleDOI
Abstract: Based on the talent management literature, this paper investigates managerial skills that are essential for managers’ job promotion. Using arguments from the human and social capital literature and following tournament logic, we claim that a manager's own experience, expertise, and network size positively affect promotion odds, while strong colleagues decrease promotion odds. Studying 7003 promotions to middle management and 3147 promotions to senior management, we find broad support for our hypotheses, but find also that network size no longer predicts promotion to senior management. Our findings have implications for individual career development and talent management programs.

52 citations


References
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Journal ArticleDOI
Abstract: Introduction In the standard economic treatment of the principal–agent problem, compensation systems serve the dual function of allocating risks and rewarding productive work. A tension between these two functions arises when the agent is risk averse, for providing the agent with effective work incentives often forces him to bear unwanted risk. Existing formal models that have analyzed this tension, however, have produced only limited results. It remains a puzzle for this theory that employment contracts so often specify fixed wages and more generally that incentives within firms appear to be so muted, especially compared to those of the market. Also, the models have remained too intractable to effectively address broader organizational issues such as asset ownership, job design, and allocation of authority. In this article, we will analyze a principal–agent model that (i) can account for paying fixed wages even when good, objective output measures are available and agents are highly responsive to incentive pay; (ii) can make recommendations and predictions about ownership patterns even when contracts can take full account of all observable variables and court enforcement is perfect; (iii) can explain why employment is sometimes superior to independent contracting even when there are no productive advantages to specific physical or human capital and no financial market imperfections to limit the agent's borrowings; (iv) can explain bureaucratic constraints; and (v) can shed light on how tasks get allocated to different jobs.

5,412 citations


"Managerial Expertise, Private Infor..." refers background in this paper

  • ...As shown in the appendix, the incentive compatibility condition in combination with the participation constraints implies that the manager’s certainty equivalent must take the form: CE(θ) = ∫ θ θ γ · β(u) du (11) 13See Holmstrom and Milgrom (1991)....

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Journal ArticleDOI
Abstract: Our estimates of the pay-performance relation (including pay, options, stockholdings, and dismissal) for chief executive officers indicate that CEO wealth changes $3.25 for every $1,000 change in shareholder wealth. Although the incentives generated by stock ownership are large relative to pay and dismissal incentives, most CEOs hold trivial fractions of their firms' stock, and ownership levels have declined over the past 50 years. We hypothesize that public and private political forces impose constraints that reduce the pay-performance sensitivity. Declines in both the pay-performance relation and the level of CEO pay since the 1930s are consistent with this hypothesis.

4,822 citations


"Managerial Expertise, Private Infor..." refers background in this paper

  • ...Hall and Liebman (1998) examine more recent data on executive compensation, and find that the average pay-performance sensitivity is somewhat higher than that documented in Jensen and Murphy (1990)....

    [...]

  • ...In a seminal paper, Jensen and Murphy (1990) empirically investigates the extent to which ceo compensation is tied to firm performance. They find a statistically significant, but economically small, relationship between ceo pay and firm performance. This evidence has raised concerns about whether the relation between pay and performance is strong enough.(6) Another well-documented empirical regularity in the executive compensation literature is that pay-performance sensitivities tend to vary quite widely across firms and industries.(7) My paper generates some potential explanations for these empirical findings. First, it shows that when managers have asymmetric information about their skills and those skills are largely firm-specific, managers will optimally receive weaker incentives than those predicted by standard moral hazard agency models. Second, my paper shows that optimal pay-performance sensitivities will vary systematically with managerial expertise. In addition, my analysis generates predictions about how pay-performance sensitivities relate to firm and industry characteristics, the extent of private information, and the nature of managers’ outside opportunities. These results can help explain some of the cross-sectional heterogeneity observed in executive compensation contracts. My model presumes that the manager’s opportunity wage is increasing in his type. This is one of the key distinctions between my model and the earlier work in the asymmetric information agency literature. Dutta (2003), Lewis and Sappington (1989a), and Maggi and Rodriguez-Clare (1995) also consider settings in which the agent’s reservation utility depends on his type. The last two papers consider regulation settings in which a regulated firm’s reservation price is negatively related to its marginal cost of production. As a consequence, the firm faces countervailing reporting incentives, i.e., it would like to overstate its marginal cost to receive a bigger cost reimbursement, but would prefer to understate its marginal cost in order to convince the regulator that its reservation price is high. While my paper (6)Jensen and Murphy (1990) find that the average ceo receives only $3....

    [...]

  • ...In a seminal paper, Jensen and Murphy (1990) empirically investigates the extent to which ceo compensation is tied to firm performance....

    [...]

  • ...In a seminal paper, Jensen and Murphy (1990) empirically investigates the extent to which ceo compensation is tied to firm performance. They find a statistically significant, but economically small, relationship between ceo pay and firm performance. This evidence has raised concerns about whether the relation between pay and performance is strong enough.(6) Another well-documented empirical regularity in the executive compensation literature is that pay-performance sensitivities tend to vary quite widely across firms and industries.(7) My paper generates some potential explanations for these empirical findings. First, it shows that when managers have asymmetric information about their skills and those skills are largely firm-specific, managers will optimally receive weaker incentives than those predicted by standard moral hazard agency models. Second, my paper shows that optimal pay-performance sensitivities will vary systematically with managerial expertise. In addition, my analysis generates predictions about how pay-performance sensitivities relate to firm and industry characteristics, the extent of private information, and the nature of managers’ outside opportunities. These results can help explain some of the cross-sectional heterogeneity observed in executive compensation contracts. My model presumes that the manager’s opportunity wage is increasing in his type. This is one of the key distinctions between my model and the earlier work in the asymmetric information agency literature. Dutta (2003), Lewis and Sappington (1989a), and Maggi and Rodriguez-Clare (1995) also consider settings in which the agent’s reservation utility depends on his type. The last two papers consider regulation settings in which a regulated firm’s reservation price is negatively related to its marginal cost of production. As a consequence, the firm faces countervailing reporting incentives, i.e., it would like to overstate its marginal cost to receive a bigger cost reimbursement, but would prefer to understate its marginal cost in order to convince the regulator that its reservation price is high. While my paper (6)Jensen and Murphy (1990) find that the average ceo receives only $3.25 for every $1000 increase in firm value. Hall and Liebman (1998) examine more recent data on executive compensation, and find that the average pay-performance sensitivity is somewhat higher than that documented in Jensen and Murphy (1990)....

    [...]

  • ...In a seminal paper, Jensen and Murphy (1990) empirically investigates the extent to which ceo compensation is tied to firm performance. They find a statistically significant, but economically small, relationship between ceo pay and firm performance. This evidence has raised concerns about whether the relation between pay and performance is strong enough.(6) Another well-documented empirical regularity in the executive compensation literature is that pay-performance sensitivities tend to vary quite widely across firms and industries.(7) My paper generates some potential explanations for these empirical findings. First, it shows that when managers have asymmetric information about their skills and those skills are largely firm-specific, managers will optimally receive weaker incentives than those predicted by standard moral hazard agency models. Second, my paper shows that optimal pay-performance sensitivities will vary systematically with managerial expertise. In addition, my analysis generates predictions about how pay-performance sensitivities relate to firm and industry characteristics, the extent of private information, and the nature of managers’ outside opportunities. These results can help explain some of the cross-sectional heterogeneity observed in executive compensation contracts. My model presumes that the manager’s opportunity wage is increasing in his type. This is one of the key distinctions between my model and the earlier work in the asymmetric information agency literature. Dutta (2003), Lewis and Sappington (1989a), and Maggi and Rodriguez-Clare (1995) also consider settings in which the agent’s reservation utility depends on his type....

    [...]


Book
01 Jan 1990
Abstract: Our estimates of the pay-performance relation (including pay, options, stockholdings, and dismissal) for chief executive officers indicate that CEO wealth changes $3.25 for every $1,000 change in shareholder wealth. Although the incentives generated by stock ownership are large relative to pay and dismissal incentives, most CEOs hold trivial fractions of their firms' stock, and ownership levels have declined over the past 50 years. We hypothesize that public and private political forces impose constraints that reduce the payperformance sensitivity. Declines in both the pay-performance relation and the level of CEO pay since the 1930s are consistent with this hypothesis.

4,646 citations


Journal ArticleDOI
Abstract: More then just a textbook, A Theory of Incentives in Procurement and Regulation will guide economists' research on regulation for years to come. It makes a difficult and large literature of the new regulatory economics accessible to the average graduate student, while offering insights into the theoretical ideas and stratagems not available elsewhere. Based on their pathbreaking work in the application of principal-agent theory to questions of regulation, Laffont and Tirole develop a synthetic approach, with a particular, though not exclusive, focus on the regulation of natural monopolies such as military contractors, utility companies, and transportation authorities. The book's clear and logical organization begins with an introduction that summarizes regulatory practices, recounts the history of thought that led to the emergence of the new regulatory economics, sets up the basic structure of the model, and previews the economic questions tackled in the next seventeen chapters. The structure of the model developed in the introductory chapter remains the same throughout subsequent chapters, ensuring both stability and consistency. The concluding chapter discusses important areas for future work in regulatory economics. Each chapter opens with a discussion of the economic issues, an informal description of the applicable model, and an overview of the results and intuition. It then develops the formal analysis, including sufficient explanations for those with little training in information economics or game theory. Bibliographic notes provide a historical perspective of developments in the area and a description of complementary research. Detailed proofs are given of all major conclusions, making the book valuable as a source of modern research techniques. There is a large set of review problems at the end of the book.

3,619 citations


Book
01 Jan 1993
Abstract: More then just a textbook, A Theory of Incentives in Procurement and Regulation will guide economists' research on regulation for years to come. It makes a difficult and large literature of the new regulatory economics accessible to the average graduate student, while offering insights into the theoretical ideas and stratagems not available elsewhere. Based on their pathbreaking work in the application of principal-agent theory to questions of regulation, Laffont and Tirole develop a synthetic approach, with a particular, though not exclusive, focus on the regulation of natural monopolies such as military contractors, utility companies, and transportation authorities. The book's clear and logical organization begins with an introduction that summarizes regulatory practices, recounts the history of thought that led to the emergence of the new regulatory economics, sets up the basic structure of the model, and previews the economic questions tackled in the next seventeen chapters. The structure of the model developed in the introductory chapter remains the same throughout subsequent chapters, ensuring both stability and consistency. The concluding chapter discusses important areas for future work in regulatory economics. Each chapter opens with a discussion of the economic issues, an informal description of the applicable model, and an overview of the results and intuition. It then develops the formal analysis, including sufficient explanations for those with little training in information economics or game theory. Bibliographic notes provide a historical perspective of developments in the area and a description of complementary research. Detailed proofs are given of all major conclusions, making the book valuable as a source of modern research techniques. There is a large set of review problems at the end of the book.

3,563 citations


"Managerial Expertise, Private Infor..." refers background in this paper

  • ...10For asymmetric information models of procurement and regulation, see Baron and Myerson (1982), Laffont and Tirole (1984), and Laffont and Tirole (1993)....

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