Publication: Executive pay with observable decisions
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2010
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Advisors
Tutors
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Fundación de Estudios de Economía Aplicada
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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.
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Keywords
Delegated expertise, Executive compensation