Paying to Make a Difference: Executive Compensation and Product Dynamics

Antonio Falato ()

No 690, 2006 Meeting Papers from Society for Economic Dynamics

Abstract: This paper develops an agency model of executive compensation in dynamic industry equilibrium. Firms differ in the quality of their products, and managers can make a difference as higher effort brings about product improvement. I show that there is an inverse relationship between the magnitude of the performance-based component of optimal compensation contracts and the degree of product differentiation, as managerial effort is less likely to make a difference for firms with more differentiated products. Empirically, I find strong evidence of this inverse relation in the compensation of US executives. In particular, I find that pay-performance sensitivity depends negatively on industry- and firm-level measures of product differentiation, even after controlling for industry fixed effects and standard measures of product market competition. Moreover, industry leaders have weaker pay-performance sensitivity than laggards, even after controlling for firm size. My findings suggest that industry is an important determinant of executive compensation

Keywords: Incentives; Optimal Contracts; Executive Compensation; Industry Dynamics (search for similar items in EconPapers)
JEL-codes: G31 G34 (search for similar items in EconPapers)
Date: 2006
New Economics Papers: this item is included in nep-bec and nep-mic
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