Endogenous Selection and Moral Hazard in Executive Compensation Contracts

46 Pages Posted: 17 Feb 2010 Last revised: 4 Apr 2012

See all articles by Chris Armstrong

Chris Armstrong

Stanford Graduate School of Business

David F. Larcker

Stanford Graduate School of Business; Stanford University - Hoover Institution; European Corporate Governance Institute (ECGI)

Che-Lin Su

University of Chicago - Booth School of Business

Date Written: February 14, 2010

Abstract

The two major paradigmsin the theoretical agency literature aremoral hazard (i.e., hidden action)and adverseselection (i.e., hiddeninformation). Prior research typically solves these problemsin isolation, as opposed to simultaneouslyincorporating both adverseselection and moral hazard features. We formulate two complementary generalized principal-agent models thatincorporate features observedin real world contracting environments (e.g., agents with power utilityand limited liability, lognormal stock price distributions,and stock options) as mathematical programs with equilibrium constraints (MPEC). We use state-of-the-art numerical algorithms to solve the resulting models. We find that many of the standard results no longer obtain when wealth effects are present. We also develop a new measure ofincentives calculated as the changein the agent's certainty equivalent under the optimal contract for a changein action evaluated at the optimal action. This measure facilitatesinterpretation of the resulting contractsand allows us to compare contracts across different contracting environments.

Keywords: Generalized Principal Agent Model, Adverse Selection, Moral Hazard, Executive Compensation, Mathematical Programs with Equilibrium Constraints

JEL Classification: C60, C61, J33, M52

Suggested Citation

Armstrong, Chris S. and Larcker, David F. and Su, Che-Lin, Endogenous Selection and Moral Hazard in Executive Compensation Contracts (February 14, 2010). Operation Research Part-2, Vol. 58, No. 4, pp. 1090-1106, July-August 2010, Rock Center for Corporate Governance at Stanford University Working Paper No. 73, Available at SSRN: https://ssrn.com/abstract=1553004

Chris S. Armstrong (Contact Author)

Stanford Graduate School of Business ( email )

655 Knight Way
E316
Stanford, CA 94305-5015
United States

HOME PAGE: http://https://www.gsb.stanford.edu/faculty-research/faculty/christopher-s-armstrong

David F. Larcker

Stanford Graduate School of Business ( email )

Graduate School of Business
518 Memorial Way
Stanford, CA 94305-5015
United States
650-725-6159 (Phone)

Stanford University - Hoover Institution ( email )

Stanford, CA 94305
United States

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Che-Lin Su

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

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