Lec 11: Executive Compensation Flashcards
What are some key facts about executive compensation in the US
Average executive pay is higher in the US than in any other company
The incentive pay component is relatively high in the US
Which key facts make current day executive compensation appear less extreme
Relatively to the US stock market, top law firm pay, hedge fund pay and sports star pay, CEO compensation appears normal or slightly decreasing in recent years
What is the basic set-up of the Principal-Agent model studied in CF?
A risk-neutral principal and a risk-neutral agent (CEO). The principal has the bargaining power. Needs to overhold the agents IR. If agent is exert effort, IC needs to be overheld. The firm will decide whether it is worth to make the agent exert effort
How do we simplify the principal agent problem here?
We assume we only pay in the good state. We then calculate the minimum required pay in the high state. Then check if this in expectation is higher than the reservation and effort cost. If not, we need to increase the expected payment.
When will managers earn the highest compensation in the P/A model?
When the relation between effort and output is moderate. Not too strong or the principal would know exactly if effort is exerted or not, and not too weak since then there would be no benefit in inducing effort
How do you find the equillibrium in the Tournament theory?
Start by calculating the probability of becoming CEO when exerting effort and when not, given all other exert effort. From these probabilities and the cost of exerting effort, the minimum CEO compensation that will make VPs exert effort can be found
When should we see large amount of tournament compensation for individual executives?
When cooperation between executives is not important
Large component of luck in outcomes
Flat organizational structure (low probability of becoming CEO)
When exerting effort only has a small effect on the probability of becoming CEO
Describe a PAM equillibrium
A salary to each CEO that satisfies:
No firm can offer another CEO a compensation that:
Will be accepted by the other firm’s CEO and
Result in an increase in the offering firm’s value
When does the PAM model make a unique equillibrium prediction?
For thing labor markets with few CEOs and firms, there are many possible equillibria.
However, with many CEOs and firms (e.g. a continuum in the limit), there will be a unique equillbrium
What is the typical production function assumption in the PAM with a continuum of firms and CEOs?
k * a. Where k is the firm quality and a is the CEO quality. There is complementarity.
How can you mathematically show that the competitive equillibrium must have positive assortative matching?
E [k * a] is higher when the covariance between k and a is maximized, e.g. when there is perfect positive correlation, e.g. positive assortative matching
How do find the wage function (of CEO quality) in the simple model where both k and a are distributed uniformly between 0 and 1?
Firm profit is ka - w(a)
Foc is: k - w’(a) = 0
For PAM, k=a, such that a - w’(a) = 0
Assume that the firm with zero quality pays, w(0) = 0
The only solution that satisfies this is w(a) = 0.5 * a^2
How to you find the density function of the wage?
General idea: rewrite the CDF as a probability given the properties of a uniform distribution. Then differentiate.
Define CDF F(t) as pr(w
What happens to pay if firms increase in value while talent it the same in the PAM model?
Pay will increase. Firm value and CEO talent is complementarities. So it will increase the marginal product of CEO
When is CEO compensation high in the Tournament model?
When there is a very flat organizational structure and the relationship between effort and output is low for VPs
