DP7442 Managerial Incentives and Stock Price Manipulation
This paper presents a rational expectations model of optimal executive compensation in a setting where managers are in a position to manipulate short-term stock prices, and managers' propensity to manipulate is uncertain. Stock-based incentives elicit not only productive effort, but also costly information manipulation. We analyze the tradeoffs involved in conditioning pay on long- versus short-term performance and characterize a second-best optimal compensation scheme. The paper shows manipulation, and investors' uncertainty about it, affects the equilibrium pay contract and the informational efficiency of asset prices. The paper derives a range of new cross-sectional comparative static results and sheds light on corporate governance regulations.