© 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
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
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)
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
Main Ideas of the Paper
• Empirical Evidence: Use Compustat merged with Execucomp (1992-2006) to test their predictions about CEO Compensation
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
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
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
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
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
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.
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
The Model
• CEO Compensation c is assumed to have 2 parts: cash salary and equity stake:
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
Theoretical Results
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
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
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
Theoretical Results II
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
Overview of Theoretical Results
• Basically solved for CEO incentives pay structure (salary vs equity), then solved for the endogenous amount of total wages.
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
What’s Really New
• Define a “new” pay-performance sensitivity measure bI, and show an invariance result with it:
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
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
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
Empirical Results
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
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)
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
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
© 2008 Robert H. Smith School of BusinessUniversity of Maryland
Thank you!
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