A Simple Explanation of the Relative Performance Evaluation Puzzle
Marco Celentani () and
Rosa Loveira-Pazó
Review of Economic Dynamics, 2006, vol. 9, issue 3, 525-540
Abstract:
We study a simple moral hazard model in which two risk-neutral owners establish incentives for their risk-averse managers to exert effort. Because the probability distributions over output realizations depend on a common aggregate shock, optimal contracts make the compensation of each manager contingent on own performance but also on a performance benchmark--the performance of the other firm. If the marginal return of effort depends on the aggregate state, optimal contracts are not monotonically decreasing in the performance benchmark. This provides a simple explanation of the Relative Performance Evaluation (RPE) Puzzle--the documented lack of a negative relationship between CEO compensation and comparative performance measures, such as industry or market performance. Our simple model can also explain one-sided RPE--the documented tendency to insulate a CEO's rewards from bad luck, but not from good luck. We clarify that our results are robust in several dimensions and we discuss other applications of our findings. (Copyright: Elsevier)
Keywords: Relative performance evaluation; optimal contracts; executive compensation. (search for similar items in EconPapers)
JEL-codes: C72 D82 M52 (search for similar items in EconPapers)
Date: 2006
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Citations: View citations in EconPapers (17)
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DOI: 10.1016/j.red.2006.04.001
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