A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium

42 Pages Posted: 19 Mar 2008 Last revised: 7 Dec 2011

See all articles by Alex Edmans

Alex Edmans

London Business School - Institute of Finance and Accounting; European Corporate Governance Institute (ECGI); Centre for Economic Policy Research (CEPR)

Xavier Gabaix

Harvard University - Department of Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI)

Augustin Landier

HEC

Multiple version iconThere are 2 versions of this paper

Date Written: June 29, 2011

Abstract

This paper presents a unified theory of both the level and sensitivity of pay in competitive market equilibrium, by embedding a moral hazard problem into a talent assignment model. By considering multiplicative specifications for the CEO's utility and production functions, we generate a number of different results from traditional additive models. First, both the CEO's low fractional ownership (the Jensen-Murphy incentives measure) and its negative relationship with firm size can be quantitatively reconciled with optimal contracting, and thus need not reflect rent extraction. Second, the dollar change in wealth for a percentage change in firm value, divided by annual pay, is independent of firm size and therefore a desirable empirical measure of incentives. Third, incentive pay is effective at solving agency problems with multiplicative impacts on firm value, such as strategy choice. However, additive issues such as perk consumption are best addressed through direct monitoring.

Keywords: Executive compensation, multiplicative preferences, pay-performance sensitivity, incentives, perks, optimal contracting, calibration

JEL Classification: D2, D3, G34, J3

Suggested Citation

Edmans, Alex and Gabaix, Xavier and Landier, Augustin, A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium (June 29, 2011). Review of Financial Studies, Vol. 22, No. 12, pp. 4881-4917, December 2009, EFA 2008 Athens Meetings Paper, Available at SSRN: https://ssrn.com/abstract=999096

Alex Edmans (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
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European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
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Centre for Economic Policy Research (CEPR) ( email )

London
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Xavier Gabaix

Harvard University - Department of Economics ( email )

Littauer Center
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI)

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

Augustin Landier

HEC ( email )

France
+33630006051 (Phone)

HOME PAGE: http://https://sites.google.com/site/augustinlandier/

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