Out of Options? Optimal Incentive Pay and Corporate Strategy Dynamics

Abstract

Good managers can give firms a competitive edge with respect to their industry rivals. This paper studies how shareholders design executive compensation contracts optimally - i.e., how they provide incentives - to exploit the competitive effect of managerial skills. A central assumption is that managerial skills, although identical ex-ante, evolve over time as managers build a track record, i.e. a history of successes or failures. Since it takes time to build up a successful track record, competition among firms is dynamic, in that laggards with relatively inexperienced managers must first catch-up with the leading edge managers before battling for leadership in the future. Incentives that optimally exploit dynamic competition imply an inverse relation between the magnitude of performance-based pay and, (i) across industries, the degree of symmetry of industry structure; (ii) within industry, firm position with respect to its peers. Empirical estimates for a large sample of U.S. executives over the 1993 to 2004 period provide strong support for these predictions. Overall, dynamic competition offers a novel rationale for the increased reliance of top executive pay on high-powered incentives, such as bonuses and stock options, over the 1990s.