Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts

John B. Donaldson, Natalia Gershun and Marc Giannoni

No 15165, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We consider a simple variant of the standard real business cycle model in which shareholders hire a self-interested executive to manage the firm on their behalf. Delegation gives rise to a generic conflict of interest mediated by a convex (option-like) compensation contract which is able to align the interests of managers and their shareholders. With such a compensation contract, a given increase in the firm's output generated by an additional unit of physical investment results in a more than proportional increase in the manager's income. We find that incentive contracts of this form can easily result in an indeterminate general equilibrium, with business cycles driven by self-fulfilling fluctuations in the manager's expectations. These expectations are unrelated to fundamentals. Arbitrarily large fluctuations in macroeconomic variables may possibly result.

JEL-codes: E32 J33 (search for similar items in EconPapers)
Date: 2009-07
New Economics Papers: this item is included in nep-bec, nep-cba, nep-cta, nep-dge and nep-mac
Note: EFG ME
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Citations: View citations in EconPapers (4)

Published as Donaldson, John B. & Gershun, Natalia & Giannoni, Marc P., 2013. "Some unpleasant general equilibrium implications of executive incentive compensation contracts," Journal of Economic Theory, Elsevier, vol. 148(1), pages 31-63.

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