Managerial Expertise, Private Information, and Pay-Performance Sensitivity
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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TL;DR: This article developed a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993-2006, finding that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly-hired CEOs.
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.
105 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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TL;DR: This paper developed a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993-2006, finding that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly hired CEOs.
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...
87 citations
Posted Content•
TL;DR: This paper developed an agency model to examine the effects of a CEO's power to pressure a CFO to bias a performance measure, like earnings, which has implications for incentive compensation, reporting quality, firm value, and information rents.
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.
77 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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TL;DR: This paper investigated managerial skills that are essential for managers' job promotion and found that a manager's own experience, expertise, and network size positively affect promotion odds, while strong colleagues decrease promotion odds.
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.
67 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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TL;DR: This paper developed an agency model to examine the effects of a CEO's power to pressure a CFO to bias a performance measure, like earnings, which has implications for incentive compensation, reporting quality, firm value, and information rents.
67 citations
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TL;DR: In this paper, the authors consider the problem of how to regulate a monopolistic firm whose costs are unknown to the regulator, and derive an optimal regulatory policy for the case in which the regulator does not know the costs of the firm.
Abstract: We consider the problem of how to regulate a monopolistic firm whose costs are unknown to the regulator. The regulator's objective is to maximize a linear social welfare function of the consumers' surplus and the firm's profit. In the optimal regulatory policy, prices and subsidies are designed as functions of the firm's cost report so that expected social welfare is maximized, subject to the constraints that the firm has nonnegative profit and has no incentive to misrepresent its costs. We explicitly derive the optimal policy and analyze its properties. IN THEIR CLASSIC PAPERS Dupuit [2] and Hotelling [5] considered pricing policies for a bridge that had a fixed cost of construction and zero marginal cost. They demonstrated that the pricing policy that maximizes consumer well-being is to set price equal to marginal cost and to provide a subsidy to the supplier equal to the fixed cost, so that a firm would be willing to provide the bridge. This first-best solution is based on a number of informational assumptions. First, the demand function is assumed to be known to both the regulator and to the firm. While the assumption of complete information may be too strong, the assumption that information about demand is as available to the regulator as it is to the firm does not seem unnatural. A second informational assumption is that the regulator has complete information about the cost of the firm or at least has the same information about cost as does the firm. This assumption is unlikely to be met in reality, since the firm would be expected to have better information about costs than would the regulator. As Weitzman has stated, "An essential feature of the regulatory environment I am trying to describe is uncertainty about the exact specification of each firm's cost function. In most cases even the managers and engineers most closely associated with production will be unable to precisely specify beforehand the cheapest way to generate various hypothetical output levels. Because they are yet removed from the production process, the regulators are likely to be vaguer still about a firm's cost function" [12, p. 684]. As this observation suggests, it is natural to expect that a firm would have better information regarding its costs than would a regulator. The purpose of this paper is to develop an optimal regulatory policy for the case in which the regulator does not know the costs of the firm. One strategy that a regulator could use in the absence of full information about costs is to give the firm the title to the total social surplus and to delegate the pricing decision to the firm. In pursuing its own interests, which would then be to maximize the total social surplus, the firm would adopt the same marginal cost pricing strategy that the regulator would have imposed if the regulator had
1,791 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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...− ∫ θ1 θ γ · (β(t)− λ) dt if θ < θ1 0 if θ ∈ [θ1, θ2] ∫ θ θ2 γ · (β(t)− λ) dt if θ > θ2 (16) 24See, for instance, Baron and Myerson (1982)....
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TL;DR: In this article, a new fifteen-year panel data set of CEOs in the largest publicly traded U. S. companies was used to find a strong relationship between firm performance and CEO compensation.
Abstract: A common view is that there is little correlation between firm performance and CEO pay. Using a new fifteen-year panel data set of CEOs in the largest, publicly traded U. S. companies, we document a strong relationship between firm performance and CEO compensation. This relationship is generated almost entirely by changes in the value of CEO holdings of stock and stock options. In addition, we show that both the level of CEO compensation and the sensitivity of compensation to firm performance have risen dramatically since 1980, largely because of increases in stock option grants.
1,421 citations
TL;DR: In this article, the authors emphasize the use of accounting data in regulatory or procurement contracts when the supplier has superior information about the cost of the project and invests in cost reduction, and the main result states that, under risk neutrality, the supplier announces an expected cost and is given an incentive contract linear in cost overruns.
Abstract: The paper emphasizes the use of accounting data in regulatory or procurement contracts when the supplier (1) has superior information about the cost of the project and (2) invests in cost reduction. The main result states that, under risk neutrality, the supplier announces an expected cost and is given an incentive contract linear in cost overruns. This (optimal) contract moves toward a fixed-price contract as the announced cost decreases. An investment choice is then introduced and the use of a rate-of-return regulation is studied.
1,278 citations
TL;DR: In this article, a series of theorems relating log-concavity and/or logconvexity of probability density functions, distribution functions, reliability functions, and their integrals are presented.
Abstract: In many applications, assumptions about the log-concavity of a probability distribution allow just enough special structure to yield a workable theory. This paper catalogs a series of theorems relating log-concavity and/or log-convexity of probability density functions, distribution functions, reliability functions, and their integrals. We list a large number of commonly-used probability distributions and report the log-concavity or log-convexity of their density functions and their integrals. We also discuss a variety of applications of log-concavity that have appeared in the literature.
1,104 citations