A Calibratable Model of Optimal CEO Incentives in Market Equilibrium

Abstract

This paper presents a united framework for understanding the determinants of both CEO incentives and total pay levels in competitive market equilibrium. It embeds a modified principal-agent problem into a talent assignment model to endogenize both elements of compensation. The model s closed form solutions yield testable predictions for how incentives should vary across arms under optimal contracting. In particular, our calibrations show that the negative relationship between the CEO s executive equity stake and arm size is quantitatively consistent with e¢ ciency and need not re ect rent extraction. Our model and data both also imply that the dollar change in wealth for a percentage change in arm value, scaled by annual pay, is independent of arm size. This may render it an attractive incentive measure as it is comparable between arms and over time. The theory also predicts a positive relationship between pay volatility and rm volatility, and that risk and effort affect total pay along the cross-section but not in the aggregate. Finally, we demonstrate that incentive compensation is executive at solving large agency problems, such as selecting corporate strategy, but smaller issues such as perk consumption are best addressed through direct monitoring.