Executive pay with observable decisions

Abstract

We propose a model of delegated expertise designed to analyze executive compensation. An expert has to pick one of two possible decisions. By exerting effort the expert can obtain private information on these decisions. The expert’s decision and its ultimate performance realization are publicly observed, but the expert’s information is not. In other words, the principal observes the expert’s decision and its realization, but does not know whether the expert expended effort to obtain information and whether he made an efficient decision conditional on the information he received. We characterize the optimal compensation contract among those that give the expert incentives to obtain information to determine the efficient decision and to make the decision that is efficient contingent on the obtained information. We show that: 1) It is generically optimal to make pay contingent on the decision made by the expert, not only on performance; 2) The expert is often rewarded for choosing alternatives that are ex-ante inefficient. 3) When decisions differ in their complexity, optimal pay-performance may be zero if the expert chooses the complex alternative. Our model highlights novel factors that should be considered in the design of executive compensation contracts, sheds light on existing compensation practices, such as rewarding executives for acquisitions, and suggests mechanisms to promote managerial innovation.