DP10566 Executive Compensation: A Modern Primer

Author(s): Alex Edmans, Xavier Gabaix
Publication Date: May 2015
Keyword(s): contract theory, executive compensation, optimal contracting, principal-agent problem, rent extraction
JEL(s): D84, G34
Programme Areas: Labour Economics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10566

This article studies traditional and modern theories of executive compensation, bringing them together under a unifying framework. We analyze assignment models of the level of pay, and static and dynamic moral hazard models of incentives, and compare their predictions to empirical findings. We make two broad points. First, traditional optimal contracting theories find it difficult to explain the data, suggesting that compensation results from 'rent extraction' by CEOs. In contrast, more modern theories that arguably better capture the CEO setting do deliver predictions consistent with observed practices, suggesting that these practices need not be inefficient. Second, seemingly innocuous features of the modeling setup, often made for tractability or convenience, can lead to significant differences in the model's implications and conclusions on the efficiency of observed practices. We close by highlighting apparent inefficiencies in executive compensation and additional directions for future research.