Equilibrium Executive Compensation

Abstract

We examine a general equilibrium dynamic economy in which each firm i) hires a manager who can divert cash flows and ii) can fire him after poor performance, generating costs to both parties. The contract is terminated when the manager's continuation value reaches his compensation at another firm net of his termination cost. The unique competitive equilibrium features overcompensation, short-termism, and excessive executive tenure unless moral hazard is minimal. When a firm increases executive pay, it increases the cost to other firms to retain their managers, in turn forcing them to raise and front-load their compensation packages. The equilibrium contract can be implemented with inside equity relinquished upon termination. Inefficiencies decrease with the firm's discount rate and the manager's termination cost and increase with the manager's discount rate, the termination cost to the firm, and the moral hazard proxy. Optimal corporate and income tax schedules and transfer fees can generate the social planner's allocation. When moral hazard is minimal, undercompensation, excessive delay in pay, and excessive firing obtain while subsidies and firing fees restore first best.