© 2008 Robert H. Smith School of Business University of Maryland A Multiplicative Model of Optimal...

© 2008 Robert H. Smith School of BusinessUniversity of Maryland

A Multiplicative Model of Optimal CEO Incentives in Market

EquilibriumBy Edmans, Gabaix, and Landier (RFS 2009)

Presented by Ben Munyan and Danmo Lin


Main Ideas of the Paper

• Theory: Applies assignment model from matching theory to CEO labor market

• Predictions: – CEO compensation should vary with size

of firm– CEO compensation structure should be the

same across firms (incentives level)


Main Ideas of the Paper

• Empirical Evidence: Use Compustat merged with Execucomp (1992-2006) to test their predictions about CEO Compensation


The Model

• Key idea of paper: multiplicative preferences, multiplicative effects of CEO talent and effort on firm performance

• Versus: Additive preferences, additive actions of CEOs to firm performance


The Model

• CEO Utility: – c is monetary compensation– e is effort: – g is a decreasing function of effort (cost of

effort) where

– Shirking increases utility by


The Model

• Effort producing function

• Interaction between random noise η and effort level

• Assume , i.e. firm’s gain from CEO exerting effort is greater than CEO’s disutility from exerting effort, so it is optimal for firm to incentivize effort.


The Model

• CEO Compensation c is assumed to have 2 parts: cash salary and equity stake:


Theoretical Results


More on the Model: Gabaix & Landier model added

• Talent assignment model (a la Shapley & Shubik)

• Continuum of firms and continuum of CEO talentsmatching where nth largest CEO is matched to nth largest firm and paid


Theoretical Results II


Overview of Theoretical Results

• Basically solved for CEO incentives pay structure (salary vs equity), then solved for the endogenous amount of total wages.


What’s Really New

• Define a “new” pay-performance sensitivity measure bI, and show an invariance result with it:


Empirical Evaluation

• Evaluate two main things:– Determinants of CEO incentives

• Really the elasticities of wealth-performance sensitivities with firm size.

• (The invariance scaling prediction)

– The level of CEO incentives• Calibrate a model to estimate the level of

incentives offered to CEO, and decide whether they are enough to preclude shirking


Empirical Results


Empirical Results II

• Find that using a conservative estimate for , that current CEO incentives deter actions for which the “private benefits of shirking” increase the CEO’s utility by an amount no greater than 0.9 times his/her annual salary

• Argue that this gives a result consistent with Jensen and Murphy’s, and argue that in a multiplicative model such compensation is sufficient– This is a more comforting argument (multiplicative effects) than

other alternative theories to why CEO compensation at large firms seemed to not have strong incentives (e.g. rent extraction)


Conclusion

• The CEO’s low fractional ownership and its negative relationship with firm size can be quantitatively reconciled with optimal contracting in a multiplicative model, and need not reflect rent extraction

• The dollar change in wealth for a % change in firm value, divided by annual pay, is independent of firm size, and therefore a desirable empirical measure of incentives– i.e. invariance result means this is a useful measure to control for size

effects

• Incentive pay is effective at solving agency problems with multiplicative impacts on firm value, such as strategy choice.– But not additive actions, such as the use of perks


Thank you!

© 2008 Robert H. Smith School of Business University of Maryland A Multiplicative Model of Optimal...

Documents

Transcript of © 2008 Robert H. Smith School of Business University of Maryland A Multiplicative Model of Optimal...