A simple theory of managerial talent, pay contracts and wage distribution

Yanhui Wu

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

Abstract: This paper develops a simple theory of pay structures and pay levels across heterogeneous agents by bringing together optimal contracts inside the firm and competitive resource allocation in the market. The central idea is that more talented people tend to create greater value but face larger conflicts of interest in their employment relationship, and different pay contracts are optimally designed to mitigate different levels of agency problems. Sorted by their talent, people are stratified into production workers, self-employed, salaried managers with low-powered performance pay, and CEOs with high-powered equity-based pay. In a general equilibrium framework, I show that the sorting of managerial talent into pay contracts is tied to firm size. The theory highlights that high-powered incentive pay and large scales of operations cause the disproportionately large wage earnings at the top, and are the main source of income inequality. Market forces that reallocate resources from smaller to larger firms tend to increase the threshold talent for becoming a manager, increase the prevalence of high-powered incentive pay, raise the top earnings, and spread out the wage distribution.

Keywords: managerial talent; limited liability; provision of incentives; pay structure; CEO pay; wage distribution (search for similar items in EconPapers)
JEL-codes: D2 J3 L1 L2 M5 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2011-08-12
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:121904

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