Identifying and Testing Models of Managerial Compensation

Abstract

This article analyses the identification and empirical content of the pure moral hazard (PMH) and the hybrid moral hazard (HMH) principal–agent models. The PMH model has hidden actions, while the HMH model has hidden information in addition to hidden actions. In both models, agents are risk averse and principals are risk neutral. The article derives the equilibrium restrictions from the optimal contract and uses the restrictions to show that the models have empirical content. For any given risk-aversion parameter, the models' other parameters are non-parametrically point identified. The risk-aversion parameter—and hence the model—are, however, only partially identified. Management's ability to manipulate accounting reports arises endogenously within HMH models, but not in all versions of PMH models. We use our framework to investigate whether shareholders contract with management recognizing that accounting reports are susceptible to manipulation and, therefore, endogenous to the incentives offered to management. The data reject all models in which accounting reports are verifiable. Furthermore, the version of the PMH in which accounting reports can be manipulated is rejected if expected compensation is restricted to be positive.