Executive compensation: A general equilibrium perspective

We study the dynamic general equilibrium of an economy where risk averse shareholders delegate the management of the firm to risk averse managers. The optimal contract has two main components: an incentive component corresponding to a non-tradable equity position and a variable “salary” component in...

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Bibliographic Details
Published in:Review of economic dynamics 2015-04, Vol.18 (2), p.269-286
Main Authors: Danthine, Jean-Pierre, Donaldson, John B.
Format: Article
Language:English
Subjects:
Dividends
Economic theory
Equilibrium
Executive compensation
Executives
General economic equilibrium
Incentives
Management theory
Optimal contracting
Organizational behaviour
Pay-for-luck
Relative performance
Risk aversion
Risk management
Stochastic discount factor
Stockholders
Studies
Wages & salaries
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Summary:We study the dynamic general equilibrium of an economy where risk averse shareholders delegate the management of the firm to risk averse managers. The optimal contract has two main components: an incentive component corresponding to a non-tradable equity position and a variable “salary” component indexed to the aggregate wage bill and to aggregate dividends. Tying a manager's compensation to the performance of her own firm ensures that her interests are aligned with the goals of firm owners and that maximizing the discounted sum of future dividends will be her objective. Linking managers' compensation to overall economic performance is also required to make sure that managers use the appropriate stochastic discount factor to value those future dividends. General equilibrium considerations thus provide a potential resolution of the “pay for luck” puzzle. We also demonstrate that one sided “relative performance evaluation” follows equally naturally when managers and shareholders are differentially risk averse.
ISSN:1094-2025
1096-6099
DOI:10.1016/j.red.2014.04.003