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An Equilibrium Model of Managerial Compensation

Author

Listed:
  • Martine Quinzii
  • Michael Magill

    (Department of Economics, University of California Davis)

Abstract

This paper studies a general equilibrium model with two groups of agents, investors (shareholders) and managers of firms, in which managerial effort is not observable and influences the probabilities of firms' outcomes. Shareholders of each firm offer the manager an incentive contract which maximizes the firm's market value, under the assumption that the financial markets are complete relative to the possible outcomes of the firms. The paper studies two sources of inefficiency of equilibrium. First, when investors are risk averse and effort influences probability, market-value maximization differs from maximization of expected utility. Second, because the optimal contract exploits all sources of information for inferring managerial effort, when firms' outputs are correlated the contract of a manager depends on the outcomes of other firms. This leads to an external effect of the effort of one manager on the compensation of other managers, which market-value maximization ignores. We show that under typical conditions these two effects lead to an under-provision of effort in equilibrium. These inefficiencies disappear however if each firm is replicated, and in the limit there is a continuum of firms of each type.

Suggested Citation

  • Martine Quinzii & Michael Magill, 2005. "An Equilibrium Model of Managerial Compensation," Working Papers 120, University of California, Davis, Department of Economics.
  • Handle: RePEc:cda:wpaper:120
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    File URL: https://repec.dss.ucdavis.edu/files/a7Fhon8cofnFUSfPW72E1Z4H/05-3.pdf
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    References listed on IDEAS

    as
    1. Prescott, Edward C & Townsend, Robert M, 1984. "General Competitive Analysis in an Economy with Private Information," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 25(1), pages 1-20, February.
    2. Prescott, Edward C & Townsend, Robert M, 1984. "Pareto Optima and Competitive Equilibria with Adverse Selection and Moral Hazard," Econometrica, Econometric Society, vol. 52(1), pages 21-45, January.
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    Cited by:

    1. Guido Maretto, 2017. "Diversification and screening," Nova SBE Working Paper Series wp610, Universidade Nova de Lisboa, Nova School of Business and Economics.
    2. Guido Maretto, 2011. "Contracts and Market: Risk Sharing with Hidden Types," Working Papers ECARES ECARES 2011-005, ULB -- Universite Libre de Bruxelles.

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    More about this item

    Keywords

    general equilibrium; incentive contracts; inefficiencies;
    All these keywords.

    JEL classification:

    • D51 - Microeconomics - - General Equilibrium and Disequilibrium - - - Exchange and Production Economies
    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • L2 - Industrial Organization - - Firm Objectives, Organization, and Behavior

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