A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium

Abstract

A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium(cid:3) Alex Edmans Xavier Gabaix Augustin Landier The Wharton School NYU Stern and NBER NYU Stern April 12, 2008 Abstract Existing compensation models typically assume that e¤ort has additive e¤ects on CEO utility. This paper considers multiplicative speci…cations for the principal-agent problem, and further embeds the problem into a talent assignment model. The result is a uni- …ed framework endogenizing both incentives and total pay levels in competitive market equilibrium. The predictions generated by multiplicative speci…cations match a number of stylized facts inconsistent with an additive model. First, the negative relationship between the CEO’s e¤ective equity stake and …rm size can be quantitatively explained by an optimal contracting model and thus need not re‡ect rent extraction. Second, our multiplicative setting predicts that the dollar change in wealth for a percentage change in …rm value, scaled by annual pay, is independent of …rm size and thus a desirable empirical measure. This independence is con…rmed in the data. Third, incentive compensation is e¤ective at solving large agency problems, such as strategy choice, but smaller issues such as perk consumption are best addressed through direct monitoring. Keywords: Executive compensation, multiplicative preferences, pay-performance sensi- tivity, incentives, perks, optimal contracting, calibration JEL Classification: D2, D3, G34, J3 …

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