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Journal Article•DOI•

Managerial Expertise, Private Information, and Pay-Performance Sensitivity

Sunil Dutta1•
University of California, Berkeley1
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.
Abstract: 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. 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.

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Citations
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Journal Article•DOI•
Does Mentor's Ability Matter for Compensation?

[...]

Georgios Farfaras1, Ivan Stetsyuk2•
Concordia University1, Université du Québec à Montréal2
16 Sep 2014-Social Science Research Network
TL;DR: This article used an agency model with moral hazard and adverse selection to study the effect of a mentor's ability on the compensation of his mentees, and found that a 1% increase in the mentor's performance increased the head coach's total compensation by $7,800.
Abstract: We use an agency model with moral hazard and adverse selection to study the effect of a mentor's ability on the compensation of his mentees. An agent who is trained by a mentor of higher ability receives valuable experience that increases not only his productivity but also his output sensitivity to effort. In our model's equilibrium, the greater productivity translates into higher total compensation, and the greater output sensitivity of effort leads to stronger incentives. We test these predictions by using data from college football coaches and we find strong empirical support for our hypotheses. Football coaches who have previously worked as assistants to head coaches of superior ability, are on average more productive. We find that, 1% increase in mentor's performance (our proxy for mentor's ability) increases head coach's total compensation by $7,800. Finally, head coaches who had better mentors received on average stronger incentives in the form of bonus payments, a result which is consistent with our model's predictions.

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

  • ...It has become standard in agency theory to use linear contracts and exponential utility for the agent (Dutta, 2008; Datar et al., 2001; Feltham and Xie, 1994; Holmstrom and Milgrom, 1987)....

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  • ...We follow Dutta (2008), and we assume that that agent’s output y is also the performance measure for compensation purposes....

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  • ...∂U(a, ã) ∂ã ∣∣∣∣ ã=a = α′(a) + β′(a)[λa+ ι(m) + δ(m)e(a)]−Rβ(a)β′(a)σ2 = 0 (17)...

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  • ...In other words, the reservation utility represents the opportunity cost 5This particular quadratic functional form of the cost function is standard in agency models (Dutta, 2008;Bernardo et al.,2001; Datar et al.,2001) and it is used mostly for convenience 9 of agent’s employment opportunities6 7....

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  • ...That makes the FOC, equation (17), an identity and we can differentiate it with respect to ability a....

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Journal Article•DOI•
CEO compensation and operational risk

[...]

Khalid Al-Amri1•
Sultan Qaboos University1
16 Mar 2017-International Journal of Business Innovation and Research
TL;DR: In this article, the authors examined the impact of operational risk on CEO compensation in the property-liability insurance industry and found that CEOs are largely insulated from firm level operational losses in terms of their total compensation.
Abstract: This study examines the impact of operational risk on CEO compensation in the property-liability insurance industry. We find that property-liability CEOs are not penalised for operational risk in terms of cash-based compensation, while they are penalised in terms of their option-based compensation. Our findings also suggest that CEOs are largely insulated from firm level operational losses in terms of their total compensation. These findings have implications for implementing optimal risk-based contracting decisions for CEO compensation contracts.
The Impact of Monitoring on Behavior and Outcome Control: Theory and Evidence on Retail Sales Productivity

[...]

Rajiv D. Banker1•
Temple University1
01 Jan 2009
TL;DR: In this paper, the authors proposed a principal-agent model with moral hazard to examine the impact of monitoring on behavior and outcome control, and they showed that the use of outcome control and enhanced monitoring enhance the expected outcome and profits of the principal.
Abstract: We propose a principal-agent model with moral hazard to examine the impact of monitoring on behavior and outcome control. Two control schemes are considered: behavior control, which corresponds to contracting on a signal of the agent’s behavior; and behavior control in conjunction with outcome control, which corresponds to contracting on the signal and outcome of interest to the principal. The greater is the extent of monitoring chosen by the principal, the more precise is the signal. The agent exerts unobservable routine and creative effort, but since creative effort is more difficult to monitor, there is a wedge in the sensitivities of the signal and outcome to creative effort. We show that the use of outcome control and enhanced monitoring enhance the expected outcome and profits of the principal. However, if the wedge is large enough, the marginal benefit of monitoring is reduced when outcome control is used, in which case the optimal level of monitoring is lower. We test the predictions of our model by examining the effect of supervisory monitoring and the impact of implementing a monetary incentives scheme on retail sales productivity. We perform a two-stage analysis of a panel of 60 months of data from a major retailer consisting of 10 experimental stores that implemented a monetary incentives scheme and 10 control stores that did not. In the first stage, we use Data Envelopment Analysis (DEA) to compute the relative productivity of the retail stores in using their labor and capital resources to generate sales. In the second stage, we regress the logarithm of DEA scores on the level of monitoring, the provision of monetary incentives, and their interaction, yielding consistent estimators (Banker and Natarajan, 2008). In accord with our agency model, our empirical results indicate that monetary incentives and the level of supervisory monitoring have significant positive effects on retail sales productivity; and the marginal impact of monitoring and the level of monitoring are diminished when monetary incentives are provided.

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

  • ...As in Dutta (2008), Datar et al. (2001), Holmstrom and Milgrom (1987), and Feltham and Xie (1994), the agent has exponential preferences with a (constant) coefficient of absolute risk aversion (CARA) of R....

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  • ...The properties of the optimal level of monitoring are not of concern to us, except when compared to the scenario in which the principal uses behavior control in conjunction with outcome control....

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  • ...Suppose the principal uses behavior and outcome control, such that the compensation contract is contingent on both the signal of the agent’s behavior (which is subject to monitoring by the principal) and the outcome of interest to the principal....

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  • ...As in Dutta (2008), Datar et al. (2001), Holmstrom and Milgrom (1987), and Feltham and Xie (1994), for tractability, we restrict our analysis to linear compensation contracts of the form (3) ),()),(( 21210 eeyeeyw yαα += , where α represents the agent’s salary and yα the sensitivity of the agent’s…...

    [...]

Journal Article•DOI•
Optimal Performance Targets

[...]

Peicong Hu1, Yiwen Li2, Korok Ray3•
University of Hong Kong1, Villanova University2, Texas A&M University3
01 Jun 2021-Journal of Management Accounting Research
TL;DR: A class of contracts that is becoming ever more common among executives, in which the manager earns a discrete bonus if his performance clears an explicit threshold, is studied, where the optimal bonus and target both increase in ability, to discourage misreporting of his private information.
Abstract: I study a class of contracts that is becoming ever more common among executives, in which the manager earns a discrete bonus if his performance clears an explicit threshold. These performance targets provide the firm with an additional instrument to resolve its moral hazard and adverse selection problems with its manager. The performance target can achieve first best under risk neutrality, with a target precisely equal to the desired effort that the firm seeks to induce. The optimal bonus increases in risk. If the manager is risk averse, the firm will shade the optimal target below equilibrium effort to provide a form of insurance to the manager, outside of the standard reduction in the bonus. When the manager has private information on his ability, the optimal bonus and target both increase in ability, to discourage misreporting of his private information. I’d like to acknowledge the helpful comments of Prasart Jongjaroenkamol, Volker Laux, Pierre Liang, Adrienne Rhodes, Florin Sabac, Jack Stecher, and seminar participants at the University of Alberta, Carnegie Mellon University, the University of Texas at Austin, and Texas A&M University. Anna Dai and Mehmet Kara provided excellent research assistance.

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

  • ...For example, Dutta (2008) assumes that the manager enjoys type- 9Note that the uniform distribution is not strictly unimodel, since it is flat everywhere....

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  • ...Indeed, a raft of papers have offered conditions under which the trade-off reverses, giving a positive relationship between risk and incentives (e.g. Dutta 2008 and Prendergast 2002)....

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  • ...Baker and Jorgensen (2003) and Dutta (2008) have called the variation on ability “information risk,” and they each provide different conditions under which incentives increase in this risk....

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  • ...Moreover, Rajan and Saouma (2006) gives conditions for a negative relationship between incentives and information risk, though their framework is a subset of the model in Dutta (2008)....

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Eine ökonomische Analyse von Referenzgruppeneffekten bei der Gestaltung von Managerbezügen

[...]

Uwe Heller
01 Jan 2009

Additional excerpts

  • ...46 2.2.3 Das erweiterte LEN-Modell von Dutta (2008) . . . . . . . . . . ....

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References
More filters
Journal Article•DOI•
Multitask Principal–Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design

[...]

Bengt Holmstrom1, Paul Milgrom2•
Yale University1, Stanford University2
01 Jan 1991-Journal of Law Economics & Organization
TL;DR: In this article, a principal-agent model that 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 is presented.
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.

5,678 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)....

    [...]

Journal Article•DOI•
Performance Pay and Top Management Incentives

[...]

Kevin Murphy1, Michael C. Jensen•
University of Southern California1
08 Mar 2001-Social Science Research Network
TL;DR: For example, the authors 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.
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.

4,859 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•
Performance pay and top-management incentives

[...]

Michael C. Jensen, Kevin Murphy
01 Jan 1990
TL;DR: For example, the authors 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.
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.

4,650 citations

Journal Article•DOI•
A Theory of Incentives in Procurement and Regulation.

[...]

Mark Armstrong1•
University of Southampton1
01 Jan 1995-The Economic Journal
TL;DR: A Theory of Incentives in Procurement and Regulation (TIIN) as mentioned in this paper is a popular textbook for regulatory economics, with a particular focus on the regulation of natural monopolies such as military contractors, utility companies and transportation authorities.
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•
A Theory of Incentives in Procurement and Regulation

[...]

Jean Tirole, Jean-Jacques Laffont
01 Jan 1993
TL;DR: A Theory of Incentives in Procurement and Regulation (TIIN) as mentioned in this paper is a popular textbook for regulatory economics, with a particular focus on the regulation of natural monopolies such as military contractors, utility companies and transportation authorities.
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.

3,602 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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Trending Questions (1)
What are the specific information of does are pay?

The specific information about pay in the paper is related to the optimal pay-performance sensitivity of compensation contracts for managers with private information about their skills.

See answers from 5 other papers