Relative Wealth Concerns, Executive Compensation, and Managerial Risk-Taking
- American Economic Journal: Microeconomics (Forthcoming)
This paper theoretically examines how relative wealth concerns affect the equilibrium contracting and systemic risk-taking. We find
that such externalities can generate pay-for-luck as an equilibrium
strategy. In expectation of pay-for-luck in other firms, tying managerial pay to luck provides insurance to managers against a compensation shortfall relative to executive peers. We also show that
an effort-inducing mechanism exists: managers have additional incentives to exert effort in utilizing investment opportunities, which
helps them keep up with their peers during industry movements.
However, pay-for-luck that is efficient within firms can nonetheless exacerbate aggregate fluctuations, especially during periods of
heightened market risk.
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