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Dynamic Managerial Compensation: A Mechanism Design Approach

Author

Listed:
  • Daniel Garrett

    (Northwestern)

  • Alessandro Pavan

    (Northwestern)

Abstract
We characterize the optimal incentive scheme for a manager who faces costly effort decisions and whose ability to generate profits for the fim varies stochastically over time. The optimal contract is obtained as the solution to a dynamic mechanism design problem with hidden actions and persistent shocks to the agent's private information. When the agent is risk-neutral, the optimal contract can often be implemented with a simple pay package that is linear in the firm's profits. Furthermore, the power of the incentive scheme typically increases over time, thus providing a possible justification for the frequent practice of putting more stocks and options in the package of managers with a longer tenure in the firm. Contrary to other explanations proposed in the literature (e.g. declining disutility of effort, learning by doing, career concerns), the optimality of seniority-based reward schemes is not driven by any particular assumption on the agent's preferences/technology. It results from an optimal allocation of the manager's informational rents over time. Building on the insights from the risk-neutral case, we then explore the properties of optimal incentive schemes for risk-averse managers. Contrary to the risk-neutral case, the optimal pay package is typically non-linear in the firm's profits (although, there are instances where it is convex function of a linear aggregator). Furthermore, we find that risk-aversion may reduce (but not necessarily eliminate) the benefit of offering incentives whose power increase, on average, over time.

Suggested Citation

  • Daniel Garrett & Alessandro Pavan, 2009. "Dynamic Managerial Compensation: A Mechanism Design Approach," 2009 Meeting Papers 375, Society for Economic Dynamics.
    • Handle: RePEc:red:sed009:375
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    References listed on IDEAS

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    Cited by:

    1. LiCalzi, Marco & Pavan, Alessandro, 2005. "Tilting the supply schedule to enhance competition in uniform-price auctions," European Economic Review, Elsevier, vol. 49(1), pages 227-250, January.
    2. Garrett, Daniel F. & Pavan, Alessandro, 2015. "Dynamic managerial compensation: A variational approach," Journal of Economic Theory, Elsevier, vol. 159(PB), pages 775-818.
    3. Gabaix, Xavier & Sannikov, Yuliy & Edmans, Alex & Sadzik, Tomasz, 2009. "Dynamic Incentive Accounts," CEPR Discussion Papers 7497, C.E.P.R. Discussion Papers.
    4. George-Marios Angeletos & Alessandro Pavan, 2007. "Socially Optimal Coordination: Characterization and Policy Implications," Journal of the European Economic Association, MIT Press, vol. 5(2-3), pages 585-593, 04-05.
    5. Daniel F. Garrett & Alessandro Pavan, 2012. "Managerial Turnover in a Changing World," Journal of Political Economy, University of Chicago Press, vol. 120(5), pages 879-925.
    6. Jean-Pierre Danthine & John Donaldson, 2015. "Executive Compensation: A General Equilibrium Perspective," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 18(2), pages 269-286, April.
    7. Xiaojun Zhao, 2015. "Optimal Income Taxations with Information Asymmetry: The Lagrange Multiplier Approach," Annals of Economics and Finance, Society for AEF, vol. 16(1), pages 199-229, May.
    8. Daniel Garrett & Alessandro Pavan, 2014. "Dynamic Managerial Compensation: On the Optimality of Seniority-based Schemes," Discussion Papers 1579, Northwestern University, Center for Mathematical Studies in Economics and Management Science.

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    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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