Optimal CEO incentives and industry dynamics

Antonio Falato () and Dalida Kadyrzhanova

No 2012-78, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: This paper develops a competitive equilibrium model of CEO compensation and industry dynamics. CEOs make product pricing and product improvement decisions subject to shareholders' compensation choices and idiosyncratic shocks to product quality. The choice of high-powered incentives optimally trades off the benefits from expected product improvements and the associated agency costs. In market equilibrium, the interaction between CEO pay and product market decisions affects the stationary distribution of firms. We characterize a dynamic feedback effect of industry structure on CEO incentives. As a result of this effect, we predict that the performance-based component of CEO pay should be higher, (i) across industries, when the degree of heterogeneity of industry structure is lower; (ii) within industries, when firms are laggards with respect to their industry peers. We empirically estimate pay-performance sensitivity for a large sample of U.S. CEOs and other top executives over the 1993 to 2004 period and find strong support for our theory. Our results offer a novel product market rationale for the increased reliance of CEO pay on bonuses and stock options over the 1990s.

Date: 2012
New Economics Papers: this item is included in nep-bec and nep-hrm
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Citations: View citations in EconPapers (9)

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Related works:
Working Paper: Optimal CEO Incentives and Industry Dynamics (2008)
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