"Executive Compensation: Salary vs. Incentive Pay: An Inconvenient Truth"
Publication type: Working paper
We examine the issue of executive compensation within an inter-temporal general equilibrium production context. Inter-temporal optimality places strong restrictions on the form of a representative manager's compensation contract, restrictions that appear to be incompatible with the fact that the bulk of many high-profile managers' compensation is in the form of various options and option-like rewards. We therefore measure the extent to which “options-like” convex contracts alone can induce the manager to adopt near-optimal investment and hiring decisions. To ask this question is essentially to ask if such contracts can effectively align the stochastic discount factor of the manager with that of the shareholder-workers. We detail exact circumstances under which this alignment is possible and when it is not. As a corollary, we also explore the business cycle and welfare consequences of suboptimal contracting.
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