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Why Do Firms Use Incentives that Have No Incentive Effects?

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Author Info
Paul Oyer (Stanford University)

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Abstract

Firms often pay individuals for group-level, industry-level, or even economy-wide performance when agency theory suggests these contracts provide minimal incentive and lead to inefficient risk bearing. This paper derives a simple model of why firms might choose to implement stock options, profit sharing, and other pay instruments that reward (or penalize) "luck." The model relies on two key assumptions: 1) adjusting the terms of employment contracts is costly to the firm, and 2) agents' outside opportunities are not constant. I explore how firm-performance-based pay will respond to variation in risk aversion, workers' reservation utility, and the correlation between a firm's performance and that of the economy as a whole. I also discuss how the model fits with widely distributed stock options (especially in risky businesses such as high technology), executive compensation, and profit sharing. The model suggests that, while agency theory has focused on incentive compatibility, the often-overlooked participation constraint can help explain many common compensation schemes.

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File URL: http://fmwww.bc.edu/RePEc/es2000/1440.pdf
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Paper provided by Econometric Society in its series Econometric Society World Congress 2000 Contributed Papers with number 1440.

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Date of creation: 01 Aug 2000
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Handle: RePEc:ecm:wc2000:1440

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  1. Marianne Bertrand & Sendhil Mullainathan, 2000. "Do CEOs Set Their Own Pay? The Ones Without Principals Do," NBER Working Papers 7604, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Barro, Jason R & Barro, Robert J, 1990. "Pay, Performance, and Turnover of Bank CEOs," Journal of Labor Economics, University of Chicago Press, vol. 8(4), pages 448-81, October. [Downloadable!] (restricted)
    Other versions:
  3. Beaudry, Paul & DiNardo, John, 1991. "The Effect of Implicit Contracts on the Movement of Wages over the Business Cycle: Evidence from Micro Data," Journal of Political Economy, University of Chicago Press, vol. 99(4), pages 665-88, August. [Downloadable!] (restricted)
  4. Benjamin E. Hermalin & Michael S. Weisbach, 1996. "Endogenously Chosen Boards of Directors and Their Monitoring of the CEO," Working Papers _004, University of California at Berkeley, Haas School of Business. [Downloadable!]
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  5. Eric Rasmusen, 1987. "Moral Hazard in Risk-Averse Teams," RAND Journal of Economics, The RAND Corporation, vol. 18(3), pages 428-435, Autumn. [Downloadable!] (restricted)
  6. Alston, Lee J. & Higgs, Robert, 1982. "Contractual Mix in Southern Agriculture since the Civil War: Facts, Hypotheses, and Tests," The Journal of Economic History, Cambridge University Press, vol. 42(02), pages 327-353, June. [Downloadable!]
  7. Card, David, 1986. "An Empirical Model of Wage Indexation Provisions in Union Contracts," Journal of Political Economy, University of Chicago Press, vol. 94(3), pages S144-75, June. [Downloadable!] (restricted)
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  8. Thomas, Jonathan & Worrall, Tim, 1988. "Self-enforcing Wage Contracts," Review of Economic Studies, Blackwell Publishing, vol. 55(4), pages 541-54, October. [Downloadable!] (restricted)
  9. Robert Drago & John S. Heywood, 1994. "The Choice of Payment Schemes: Australian Establishment Data," Labor and Demography 9402001, EconWPA, revised 04 Feb 1994. [Downloadable!]
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  10. Patrick Legros & Steven A. Matthews, 1992. "Efficient and Nearly Efficient Partnerships," Discussion Papers 991R, Northwestern University, Center for Mathematical Studies in Economics and Management Science. [Downloadable!]
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  11. Robert Gibbons & Kevin J. Murphy, 1990. "Relative performance evaluation for chief executive officers," Industrial and Labor Relations Review, ILR Review, ILR School, Cornell University, vol. 43(3), pages 30-51, February.
  12. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March. [Downloadable!] (restricted)
  13. Milton Harris & Bengt Holmstrom, 1981. "A Theory of Wage Dynamics," Discussion Papers 488, Northwestern University, Center for Mathematical Studies in Economics and Management Science. [Downloadable!]
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  14. Rajesh K. Aggarwal & Andrew A. Samwick, 1999. "Executive Compensation, Strategic Competition, and Relative Performance Evaluation: Theory and Evidence," Journal of Finance, American Finance Association, vol. 54(6), pages 1999-2043, December. [Downloadable!] (restricted)
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  15. Bengt Holmstrom, 1982. "Moral Hazard in Teams," Bell Journal of Economics, The RAND Corporation, vol. 13(2), pages 324-340, Autumn. [Downloadable!] (restricted)
  16. repec:fth:prinin:431 is not listed on IDEAS
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