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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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Posted Content•
The Relation between CEO Compensation and Past Performance

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Rajiv D. Banker1, Masako N. Darrough2, Rong Huang2, Jose M. Plehn-Dujowich1•
Temple University1, City University of New York2
18 Jul 2012-Social Science Research Network
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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Journal Article•DOI•
The Relation between CEO Compensation and Past Performance

[...]

Rajiv D. Banker1, Masako N. Darrough2, Rong Huang2, Jose M. Plehn-Dujowich1•
Temple University1, Baruch College2
01 Jan 2013-The Accounting Review
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•
Implications of Power: When the CEO Can Pressure the CFO to Bias Reports

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Henry L. Friedman1•
University of California, Los Angeles1
18 Jun 2014-Social Science Research Network
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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Journal Article•DOI•
Talent Management and Career Development: What it Takes to Get Promoted

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Jörg Claussen1, Jörg Claussen2, Thorsten Grohsjean3, Johannes Luger4, Gilbert Probst5 •
Ludwig Maximilian University of Munich1, Copenhagen Business School2, Bocconi University3, University of St. Gallen4, University of Geneva5
27 Sep 2013-Social Science Research Network
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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Journal Article•DOI•
Implications of power: When the CEO can pressure the CFO to bias reports

[...]

Henry L. Friedman1•
University of California, Los Angeles1
01 Aug 2014-Journal of Accounting and Economics
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

References
More filters
Journal Article•DOI•
The Capital Budgeting Process: Incentives and Information

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Milton Harris, Artur Raviv
01 Sep 1996-Journal of Finance
TL;DR: In this article, the authors study the capital allocation process within firms and investigate how the budgeting process may be expected to vary with firm or division characteristics such as investment opportunities and the technology for information transfer.
Abstract: We study the capital allocation process within firms. Observed budgeting processes are explained as a response to decentralized information and incentive problems. It is shown that these imperfections can result in underinvestment when capital productivity is high and overinvestment when it is low. We also investigate how the budgeting process may be expected to vary with firm or division characteristics such as investment opportunities and the technology for information transfer. THERE IS GENERAL AGREEMENT that investment decisions are the most important decisions made by corporations. The choice of projects and the level of investment is critical not just for stakeholders of the firm but also for the economic well-being of society as a whole. It has been alleged that U.S. firms invest too little and tend to overemphasize short-term results. For example, Porter (1992), citing Poterba and Summers (1992), asserts that U.S. firms use hurdle rates to evaluate investment projects that are higher than their estimated costs of capital. To understand the investment behavior of firms, one must consider both the process by which external capital is made available to firms and the process by which internally and externally raised capital is allocated to investment projects within the firm. Considerable attention has been paid to how firms raise external capital. The fundamental insight in this area is the celebrated result of Modigliani and Miller (MM) that capital structure is irrelevant in the absence of capital market frictions. Accordingly, in the three decades since their contribution, research on how external capital is raised has focused on market frictions, including information and incentive problems. Relatively little research has focused on the internal allocation process and its relationship to the organization of the firm. Modern finance theory prescribes allocating capital according to the net present value (NPV) rule. Just as the MM result itself provides no theory of the arrangements under which

382 citations

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

  • ...One can think of λ · γ as a measure of the marginal productivity of managerial expertise outside the firm because Baldenius (2003), Dutta and Reichelstein (2002), Harris, Kriebel and Raviv (1982), and Harris and Raviv (1996). the manager’s opportunity wage w(·) increases in θ at this rate....

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Journal Article•DOI•
Stock-based pay in new economy firms

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Kevin Murphy1•
University of Southern California1
01 Jan 2003-Journal of Accounting and Economics
TL;DR: In this paper, the effect of stock-based compensation on the performance of new and old economy firms is investigated, and it is shown that differences in pay practices reflect accounting considerations, perceived costs, and competitive inertia.

362 citations

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

  • ...Empirical evidence in Anderson et al. (2000), Core and Guay (2001), Ittner et al. (2003), and Murphy(2003) suggest that performance-based pays (through stock options and other performance measures) play a more prominent role in knowledge-intensive new-economy firms than in traditional firms....

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  • ...…managers in new economy knowledge-based firms.20 Consistent with this prediction, Anderson et al. (2000), Core and Guay (2001), Ittner et al. (2003), and Murphy (2003) find that performance-based compensation is more prominent in knowledge-intensive new economy firms than in traditional firms....

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Journal Article•DOI•
The Power of Incentives

[...]

Edward P. Lazear1•
Hoover Institution1
01 May 2000-The American Economic Review
TL;DR: The most typical form of variable pay is the piece rate, which was more prevalent during the early part of the 20th century than it is at the beginning of the 21st.
Abstract: Variable pay is usually defined as pay that is tied to some measure of worker output. The most typical form of variable pay historically was the piece rate, which was more prevalent during the early part of the 20th century than it is at the beginning of the 21st. There is a resurgence in variable pay, particularly as it relates to executives, whose pay is tied to output through some mechanism like stock options or bonuses that depend on individual or firm performance. Why use variable pay? The typical reaction is that variable pay provides incentives to put forth effort. Although true, discrete-pay schemes also generate incentives. Much of the confusion in the literature results from the use of the terms "high-powered" and "low-powered" incentives, which connote difference in ability to elicit worker effort.' It is more informative to make distinctions between discrete and continuous pay and between inputbased and output-based pay.2 Pay structures can be summarized by the following equation:

331 citations

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

  • ...The assumption of full participation is also imposed in Dutta (2003), Lewis and Sappington (1989a) and (1989b), and Maggi and Rodriguez-Clare (1995). Julien (2000) allows for the possibility of partial participation and derives some general properties of optimal participation sets....

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  • ...The assumption of full participation is also imposed in Dutta (2003), Lewis and Sappington (1989a) and (1989b), and Maggi and Rodriguez-Clare (1995)....

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Journal Article•DOI•
On Countervailing Incentives

[...]

Giovanni Maggi1, Andres Rodriguez-Clare1•
University of Chicago1
01 Jun 1995-Journal of Economic Theory
TL;DR: In this article, the authors extended and unified previous work on optimal contracts under countervailing incentives, shedding light in particular on the relation between countervail incentives and pooling ("inflexible rules") and showed that the nature of the optimal contract depends crucially on whether the agent′s utility is quasiconcave or quasicovex in the private parameter.

296 citations

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

  • ...(2)In reviewing the extant literature on executive compensation contracts, Murphy (1999) writes: “ceos have superior skills or information....

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  • ...(2)In reviewing the extant literature on executive compensation contracts, Murphy (1999) writes: “ceos have superior skills or information. Unobservable actions cannot be the driving force underlying executive contracts...” (3)For a review of the changing nature of business enterprises, see Zingales (2000) and Rajan and Zingales (2000). (4)For a further discussion of the distinction between firm-specific and general expertise, see Becker (1964)....

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  • ...As reviewed in Prendergast (2002), however, the empirical evidence has been quite mixed....

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  • ...(2)In reviewing the extant literature on executive compensation contracts, Murphy (1999) writes: “ceos have superior skills or information. Unobservable actions cannot be the driving force underlying executive contracts...” (3)For a review of the changing nature of business enterprises, see Zingales (2000) and Rajan and Zingales (2000)....

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Journal Article•DOI•
Accounting income, stock price, and managerial compensation

[...]

Robert M. Bushman1, Raffi Indjejikian1•
University of Chicago1
01 Jan 1993-Journal of Accounting and Economics
TL;DR: In this article, the authors employ an agency model where a manager has a two-dimensional action choice to study how the information content of earnings affects the design of compensation contracts based on earnings and price.

293 citations

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

  • ...See, for instance, Bushman and Indjejikian (1993) and Feltham and Xie (1992)....

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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