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VoxEU Column Labour Markets

A theory of fair CEO pay

Performance-related pay provides an ex-post reward to CEOs and can ensure that they feel fairly treated. If a CEO’s pay falls short of what is perceived as fair, it can be a strong demotivator. This column studies how fairness concerns affect optimal CEO contracts. The most efficient contract resembles performance shares, which provide fair wages if performance is good.

CEO pay is a controversial topic. While academic research studies the finer details of incentive design, critics argue that financial incentives should be unnecessary in the first place. In standard economic theories, such as Holmström (1979), incentives are needed because the CEO is work-shy. Hard work is unpleasant for the CEO, so the CEO will only exert effort if she is compensated for the resulting improvement in firm performance. This financial reward will allow the CEO to increase consumption, for example, to buy a yacht. If the pleasure provided by that yacht exceeds the unpleasantness of hard work, the CEO will exert effort; otherwise, they will refuse.

Such models form the backbone of decades of theoretical research on executive compensation, as surveyed by Edmans and Gabaix (2016). In turn, decades of empirical research have tested the predictions of these models, as summarised by Edmans et al. (2017). While we have learned a great deal from these standard economic theories, they do not capture the primary forces driving CEO pay in practice. Starting with the cost of effort, it is not clear how high this cost is.

In a recent survey of directors and investors, Edmans et al. (2021, 2022) find that intrinsic motivation and personal reputation are the primary drivers of CEO effort. Rather than viewing effort as unpleasant, CEOs are intrinsically motivated to do a good job or to be seen by their colleagues, their peers, and wider society as having done a good job. Similarly, the pleasure from additional consumption is likely low because CEOs are already wealthy and most of their material needs are likely satisfied. If your CEO is more motivated by a yacht than by doing a good job, you’ve got the wrong CEO.

Instead of only being used to provide ex ante economic incentives, the survey of Edmans et al. (2021, 2022) shows that an important function of performance-related pay is to provide an ex-post reward – to ensure that the CEO feels that they have been fairly treated. The CEO compares their actual pay to what they perceive to be a fair level of pay; if their actual pay falls short of this perceived fair pay, the CEO suffers a significant loss of utility. This is consistent with prior research suggesting that pay is a hygiene factor – pay above a certain level provides limited additional motivation, but pay below that level is a strong demotivator (e.g. Hertzberg 1959).

Edmans, Gosling, and Jenter (2021, 2022) find that perceived fair pay depends on many factors, with an important one being firm value. If firm value has increased due to CEO effort, directors and investors believe it is fair to reward the CEO for this increase. If firm value has increased (or decreased) due to circumstances outside the CEO’s control, the CEO should share in this good (or bad) luck. That a share of firm value is perceived as a fair payment is consistent with the widely-replicated ultimatum game. If one party has been gifted an endowment, the other believes it is fair to be offered a sizeable share and will sacrifice their own consumption to punish an unfair offer.

In a new paper (Chaigneau et al. 2023), we study the implications of such fairness concerns for the optimal design of CEO pay. We start with the standard framework of risk neutrality and limited liability, as studied by Innes (1990). The only change that we make is that, in addition to being motivated by traditional consumption utility, the CEO also has fairness concerns – if the actual wage falls below the perceived fair wage, the CEO suffers disutility, the magnitude of which is increasing in this discrepancy. By making this one change, we are able to identify how fairness concerns affect optimal CEO contracts. In our baseline model, the fair wage is linear in output, i.e. the CEO believes they should receive a certain percentage of output, and the disutility is linear in the discrepancy.

The optimal contract involves a threshold below which the CEO is paid zero, and above which they receive the fair wage. This contradicts the intuition that fairness concerns will lead to the CEO always receiving a fair wage. Instead, fairness concerns mean that unfairness can be a powerful motivator. If output is sufficiently low that it is unlikely that the CEO has worked, the firm pays the CEO the most unfair possible wage of zero. Only if output exceeds a lower threshold is the CEO paid the fair wage. Depending on parameter values, there may also be an additional upper threshold above which the CEO is paid the firm’s entire output.

Innes (1990) showed that, without fairness concerns, the optimal contract is ‘live-or-die’ – the agent receives zero if output is below a threshold, and the entire output above it. The intuition is that the best way to provide incentives is to pay the CEO only for very high outputs. However, such a contract is inefficient under fairness concerns. Even if the CEO works, output may fall below this threshold due to bad luck. If the CEO is paid zero, they suffer significant disutility due to unfairness, which erodes the CEO’s incentive to work. Thus, it is efficient to offer the CEO a fair wage for intermediate output levels.

We show that, under certain conditions, the threshold is decreasing in the CEO’s fairness concerns – when the CEO is more concerned about fairness, the range of outputs over which they receive a fair wage rises. In addition, this range is increasing in the volatility of the output distribution. The greater this volatility, the likelier it is that output will be moderate even if the CEO works, and so the more important it is to reward the CEO with a fair wage rather than zero.

The contract resembles performance shares, where the CEO receives shares that are forfeited if performance falls below a threshold, i.e. their value drops discontinuously to zero. Even though performance shares are frequently offered in reality (e.g. Bettis et al. 2010), standard models, such as Holmström (1979), do not predict discontinuous contracts. Innes (1990) predicts a sharp discontinuity where the CEO’s pay increases from zero to the entire output, once output crosses a threshold, but such sharp discontinuities do not exist in reality. Our paper obtains milder and thus more realistic discontinuities: when performance crosses a threshold, the wage jumps up from zero, but not to the entire output. Intuitively, performance shares provide fair wages if performance is good and unfair wages (zero) if performance is bad. This is an efficient way to motivate good performance.

We then extend the model to a non-linear one, where the fair wage is increasing but not necessarily linear in output, the utility loss is increasing but not necessarily linear in unfairness, and utility is increasing and concave in the wage if it is fair. The key features of the model continue to hold.

In all variants of the model, pay is increasing in output even if the CEO does not need financial incentives to work hard, for example, due to intrinsic motivation. This is because fair wages are instead needed to persuade the CEO to accept the contract. If the CEO knows that they will not be rewarded for good performance – i.e. the CEO does a good job but is not recognised for it afterwards – they will not accept the company to begin with. As a survey respondent in Edmans et al. (2022) remarked, no talented person would stay at a firm where they do not feel appreciated. Thus, observing that CEOs are paid for performance in reality need not automatically imply that they need financial incentives; instead, pay-for-performance can be driven by fairness concerns rather than incentive concerns.

A frequent criticism of performance-related pay for CEOs is that it should not be necessary – the CEO should be intrinsically motivated to exert effort or the board should monitor CEO effort. Our model demonstrates that performance-related pay may be optimal not to induce effort, but to attract or retain a CEO with fairness concerns. CEOs are paid for performance not because they would refuse to work without the carrot of an extra yacht, but because it is human to want to be recognised for a job well done.


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Edmans, A, X Gabaix, and D Jenter (2017), “Executive compensation: A survey of theory and evidence”, in B E Hermalin and M S Weisbach (eds.), Handbook of the Economics of Corporate Governance, North-Holland/New York: Elsevier.

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