Abstract
This paper considers the design of managerial compensation contracts and their impact on corporate investment decisions and the managerial effort decision. The model relates the compensation scheme to outside share ownership and managerial bargaining position. Using the methods of mechanism design under asymmetric information, a shift in favor of effort is documented in the case where managerial bargaining strength is weak, while a shift toward more use of capital investment results from strong managerial bargaining power. The model distinguishes managerial equity holdings from contingent compensation contracts. Our results are related to the empirical literature on pay‐performance sensitivities.
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