Celentani, MarcoLoveira, Rosa2012-10-032012-10-032006-07Review of Economic Dynamics, july 2006, vol. 9, n. 3, p. 525-5401094-2025http://hdl.handle.net/10016/4824We study a simple moral hazard model in which two risk-neutral owners establish incentives for their risk-averse managers to exert effort. Because the probability distributions over output realizations depend on a common aggregate shock, optimal contracts make the compensation of each manager contingent on own performance but also on a performance benchmark—the performance of the other firm. If the marginal return of effort depends on the aggregate state, optimal contracts are not monotonically decreasing in the performance benchmark. This provides a simple explanation of the Relative Performance Evaluation (RPE) Puzzle—the documented lack of a negative relationship between CEO compensation and comparative performance measures, such as industry or market performance. Our simple model can also explain one-sided RPE—the documented tendency to insulate a CEO's rewards from bad luck, but not from good luck. We clarify that our results are robust in several dimensions and we discuss other applications of our findings.text/plainapplication/pdfeng© ElsevierRelative performance evaluationOptimal contractsExecutive compensationresearch articleC72D82M52Economía10.1016/j.red.2006.04.001open access5253540Review of Economic Dynamics9