Liquidity, Information Aggregation, and Market-Based Pay in an Efficient Market

Florian Heider and Riccardo Calcagno

No 11298, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper studies the usefulness of making the income of a CEO depend on the stock price of the firm he runs. We assume the stock market is efficient and find that other public information about CEO performance, e.g., accounting information, is not used to determine CEO pay. But because of the feedback loop between CEO actions and the stock price, the price does not fully reflect the consequences of CEO shirking for the value of the firm. The optimal incentive contract increases stock-based pay in order to increase the sensitivity of CEO income to shirking and thus deter it. This effect is stronger when traders have worse information, which can explain the prevalence of stock-based pay in hard-to-value firms. Our model derives a measure of the wedge between financial and economic efficiency, and generates new insights about the role of market conditions such as liquidity for optimal pay contracts.

Keywords: Market-based pay; Efficient markets; Liquidity; Information aggregation (search for similar items in EconPapers)
JEL-codes: D86 G14 G34 (search for similar items in EconPapers)
Date: 2016-05
New Economics Papers: this item is included in nep-acc, nep-bec, nep-cta and nep-hrm
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