Abstract
The persistently low pay-performance sensitivity between executive compensation and firm performance has puzzled both practitioners and academics. We propose a hybrid model that incorporates both moral hazard and adverse selection problems to explain this puzzle. We argue that the managerial labor market is heterogeneous in nature, not homogeneous as assumed by the pure moral hazard model and empirical work based on this model. We demonstrate that the optimal pay-performance sensitivity derived from the hybrid model is lower than that derived from the pure moral hazard model. Furthermore, we also show that pay-performance sensitivity is a function of the mix of types in the market. The more capable managers there are in the market, the more likely the market's average pay-performance sensitivity is high. We then conduct an empirical test and find evidence that is consistent with the prediction of our model.
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