Equilibrium Executive Compensation

47 Pages Posted: 10 Jun 2021 Last revised: 22 Jul 2021

See all articles by Gilles Chemla

Gilles Chemla

Imperial College Business School; CNRS ; Centre for Economic Policy Research (CEPR)

Alejandro Rivera

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

Liyan Shi

Einaudi Institute for Economics and Finance

Date Written: June 8, 2021

Abstract

We examine a general equilibrium dynamic economy in which each firm i) hires a manager who can divert cash flows and ii) can fire him after poor performance, generating costs to both parties.
The contract is terminated when the manager's continuation value reaches his compensation at another firm net of his termination cost. The unique competitive equilibrium features overcompensation, short-termism, and excessive executive tenure unless moral hazard is minimal. When a firm increases executive pay, it increases the cost to other firms to retain their managers, in turn forcing them to raise and front-load their compensation packages. The equilibrium contract can be implemented with inside equity relinquished upon termination. Inefficiencies decrease with the firm's discount rate and the manager's termination cost and increase with the manager's discount rate, the termination cost to the firm, and the moral hazard proxy. Optimal corporate and income tax schedules and transfer fees can generate the social planner's allocation. When moral hazard is minimal, undercompensation, excessive delay in pay, and excessive firing obtain while subsidies and firing fees restore first best.

Keywords: Executive compensation, externalities, dynamic optimal contracts, short-termism, turnover.

JEL Classification: G30, J33, D86

Suggested Citation

Chemla, Gilles and Rivera, Alejandro and Shi, Liyan, Equilibrium Executive Compensation (June 8, 2021). Available at SSRN: https://ssrn.com/abstract=3862731 or http://dx.doi.org/10.2139/ssrn.3862731

Gilles Chemla

Imperial College Business School ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom
+44 207 594 9161 (Phone)
+44 207 594 9210 (Fax)

CNRS ( email )

Dauphine Recherches en Management
Place du Marechal de Lattre de Tassigny
Paris, 75016
France
331 44054970 (Phone)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Alejandro Rivera (Contact Author)

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

2601 North Floyd Road
P.O. Box 830688
Richardson, TX 75083
United States

HOME PAGE: http://jindal.utdallas.edu/faculty/alejandro-rivera

Liyan Shi

Einaudi Institute for Economics and Finance ( email )

Via Due Macelli, 73
Rome, 00187
Italy

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