Selection Versus Incentives in Incentive Pay: Evidence from a Matching Model

Abstract

Higher incentive pay is associated with higher firm value. I introduce a model of CEO-firm matching to disentangle the two confounding effects that drive this result. First, higher incentive pay directly induces more effort; second, talented CEOs sort into firms pay higher incentive pay. I find that both effects contribute to the result, with the selection effect accounting for almost one-quarter of the total effect. The relative importance of the selection effect is the largest in submarkets with high talent mobility and in more recent years.