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Risk Aversion, Performance Pay, and the Principal-Agent Problem
Joseph G. Haubrich
Federal Reserve Bank of Cleveland
This paper calculates numerical solutions to the principal-agent problem and compares the results to the stylized facts of CEO compensation. The numerical predictions come from parameterizing the models of Grossman and Hart and of Holmstrom and Milgrom. While the correct incentives for a CEO can greatly enhance a firm's performance, providing such incentives need not be expensive. For many parameter values, CEO compensation need increase only by about $10 for every $1,000 of additional shareholder value; for some values, the amount is 0.003 cents.
The gap between theory and reality looms especially large in questions of executive compensation. Pay does not depend enough on performance. Compensation for top executives increases a mere $3.25 per $1,000 gain in shareholder value according to Jensen and Murphy (1990b). In fact, the gap is more illusory than real. That is fortunate for economists, who use the principal-agent theory behind executive compensation to explain debt, equity, dividends, and the thrift debacle. Jensen and Murphy use their findings to challenge the principalagent paradigm. The pay-performance sensitivity of .003 is a far cry from the 1.0 predicted by the risk-neutral version of principal-agent theory. Their estimate challenges broader versions of the theory to explain the data without invoking absurd values of risk aversion or I thank Charles Kahn and Kevin J. Murphy, seminar participants at the Weatherhead School, and an anonymous referee for helpful comments. Uournal of Political Economy, 1994, vol. 102, no. 21 ? 1994 by The University of Chicago. All rights reserved. 0022-3808/94/0202-0002$01.50
chief executive officer (CEO) ability. In this paper I hope to show how standard theory can meet that challenge. Using reasonable assumptions, principal-agent theory can yield quantitative solutions in line with the empirical results of Jensen and Murphy. Grossman and Hart (1983) provide a tractable solution for a two-state, finite-action model. Holmstrom and Milgrom (1987) provide a tractable solution for a continuous-action model. This paper uses those frameworks to obtain quantitative results for executive pay. With the choice of a few parameters, it becomes possible to match...