Finance and Economics Discussion Series (FEDS)
October 2012
Optimal CEO Incentives and Industry Dynamics
Antonio Falato and Dalida Kadyrzhanova
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.
Full paper (Screen Reader Version)Keywords: CEO compensation, product market structure
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