DP9000 Stock Market Tournaments

Author(s): Emre Ozdenoren, Kathy Yuan
Publication Date: June 2012
Keyword(s): Contractual Externalities, Excessive Risk-Taking, Insufficient Risk-Taking, Stock-Based Incentives
JEL(s): D86, G01, G30
Programme Areas: Financial Economics, Industrial Organization
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=9000

We propose a new theory of suboptimal risk-taking based on contractual externalities. We examine an industry with a continuum of firms. Each firm's manager exerts costly hidden effort The productivity of e ffort is subject to systematic shocks. Firms' stock prices reflect their performance relative to the industry average. In this setting, stock-based incentives cause complementarities in managerial effort choices. Externalities arise because shareholders do not internalize the impact of their incentive provision on the average effort. During booms, they over-incentivise managers, triggering a rat-race in effort exertion, resulting in excessive risk relative to the second-best. The opposite occurs during busts.