Title: Dynamically Optimal Executive Compensation when Reservation Utilities are History-Dependent
Abstract:This paper considers a moral hazard problem in an infinite-horizon, principal-agent framework characterized by limited commitment and history-dependent reservation utilities. I prove existence and con...This paper considers a moral hazard problem in an infinite-horizon, principal-agent framework characterized by limited commitment and history-dependent reservation utilities. I prove existence and construct a reduced equivalent representation of the problem that can be addressed by numerical techniques. In computing the endogenous state space, I use an innovative algorithm which does not rely on the convexity of the underlying set. Further on, I focus on the estimation of the dynamically optimal compensation for US executives. The results show that with a loose upper bound on wages, the optimal contract can support extremely high values for the expected discounted utility of the CEO when the participation of the principal is not guaranteed. However, when solving for the self-enforcing contract, these values naturally disappear since they violate principal's participation constraint. In case of positive correlation between stock prices and agent's reservation utilities, the minimum utility the CEO can be promised for initial histories characterized by lower reservation utility is boosted by higher reservation utilities for other states. This suggests that the participation constraint of the agent does not bind in states characterized by low stock prices. In other words, the optimal contract provides the agent with some insurance against bad outcomes, which ultimately smooths his/her consumption across (initial history) states. Exerting effort appears to be the predominant strategy for the principal, but shirking may still be optimal when the agent is rich enough. The optimal wage scheme and the future utility of the CEO tend to grow in both current utility and in the future realization of the stock price.Read More
Publication Year: 2008
Publication Date: 2008-03-01
Language: en
Type: article
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Cited By Count: 1
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