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 effort 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.