DP6555 Executive Compensation: The View from General Equilibrium

Author(s): Jean-Pierre Danthine , John B Donaldson

Publication Date: November 2007

Keyword(s): incentives , optimal contracting , stochastic discount factor

JEL(s): E32 , E44

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP6555.asp.asp

We study the dynamic general equilibrium of an economy where risk averse shareholders delegate the management of the firm to risk averse managers. The optimal contract has two main components: an incentive component corresponding to a non-tradable equity position and a variable 'salary' component indexed to the aggregate wage bill and to aggregate dividends. Tying a manager's compensation to the performance of her own firm ensures that her interests are aligned with the goals of firm owners and that maximizing the discounted sum of future dividends will be her objective. Linking managers' compensation to overall economic performance is also required to make sure that managers use the appropriate stochastic discount factor to value those future dividends.