Sensitivity of CEO Pay to Shareholder Wealth in a Dynamic Agency Model

The empirical literature has pointed out several stylized facts about Executive Compensation Schemes. In particular, with respect to the sensitivity of compensation to shareholder wealth, three findings stand out. First, the short-run response of compensation to performance is lower than the one implied by static agency models. Second, the cumulative response is considerably higher. Finally, the sensitivity is inversely proportional to firm size. In this paper, building on work by Wang (1997), we model the relationship between shareholders and their CEO as a repeated principal-agent relationship with hidden action. We introduce two innovations with respect to the existing literture. First, the scale of operations (level of capital stock) is determined optimally by the CEO, conditionally on the provisions of the compensation contract and on the evolution of the technology's productivity. Second, and most importantly, in our setup the action of the CEO has an impact on both current and future levels of firm's productivity. We are able to show by means of numerical simulation that the optimal compensation scheme in this environment displays features that are qualitatively in line with the empirical evidence on pay-performance sensitivity.