Aversion to the variability of pay and optimal incentive contracts

Pierre Chaigneau

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: In a moral hazard setting with a performance additive in effort and a symmetrically distributed noise term, I show that compensation contracts which are convex in performance are suboptimal when the agent has mean-variance preferences. With step contracts, I show that sticks are more efficient than carrots: an exogenously given lower bound on payments is binding at the optimum. Intuitively, the variance of the agent's pay conditional on a high effort should be as low as possible, while it should be as high as possible conditional on a low effort. From an ex ante perspective, which is relevant for effort inducement, this maximizes the rewards associated to high effort, and the punishments associated to low effort. These results call into question the widespread use of stock-options and contracts with rewards-like features to provide incentives to risk averse executives.

Keywords: compensation; contract theory; incentives; moral hazard; optimal contracts (search for similar items in EconPapers)
JEL-codes: D86 J33 M52 (search for similar items in EconPapers)
Pages: 35 pages
Date: 2010-07-01
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http://eprints.lse.ac.uk/119086/ Open access version. (application/pdf)

Related works:
Working Paper: Aversion to the variability of pay and optimal incentive contracts (2010)
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