Dynamic Managerial Compensation: a Mechanism Design Approach
Daniel Garrett, Alessandro Pavan*
Date: 2009-05-15 2:00 pm – 2:30 pm
Last modified: 2009-04-17
Abstract
We characterize the optimal incentive scheme for a manager who faces costly effort decisions and whose ability to generate pro
ts for the fi
rm varies stochastically over time. The optimal contract is obtained as the solution to a dynamic mechanism design problem with hidden actions and persistent shocks to the agent's private information. When the agent is risk-neutral, the optimal contract can often be implemented with a simple pay package that is linear in the
firm's pro
fits. Furthermore, the power of the incentive scheme typically increases over time, thus providing a possible justi
cation for the frequent practice of putting more stocks and options in the package of managers with a longer tenure in the
rm. Contrary to other explanations proposed in the literature (e.g. declining disutility of effort, career concerns), the optimality of seniority-based reward schemes is not driven by any particular assumption on the agent's preferences/technology. It results from an optimal allocation of the manager's informational rents over time. Building on the insights from the risk-neutral case, we then explore the properties of optimal incentive schemes for risk-averse managers. Contrary to the risk-neutral case, the optimal pay package is typically non-linear in the fi
rm's profi
ts (although, there are instances where it is a convex function of a linear aggregator). Furthermore, we
nd that risk-aversion may contribute to reducing (but not necessarily eliminate) the benefi
t of offering incentives whose power increase, on average, over time.