Why Do Firms Use Incentives that have No Incentive Effects?

Preprint
Publisher Website
Google Scholar
Abstract
Firms often pay individuals for group-level, industry-level, or even economy-wide performance even though agency theory suggests these contracts provide minimal incentive and lead to inefficient risk bearing. This paper derives a simple model that illustrates why firms might choose to implement stock options, profit sharing, and other pay instruments that reward (or penalize) "luck." The model relies on two key assumptions: 1) firms incur cost when adjusting the terms of employment contracts, and 2) agents' outside opportunities are correlated with their firms' performance. I explore how firm-performance-based pay will respond to variation in risk aversion, workers' reservation utility, and the correlation between a firm's performance and that of the economy as a whole. I also discuss how the model fits with widely distributed stock options (especially in risky businesses such as high technology), executive compensation, and profit sharing, as well as how the model helps explain the popularity of such financial instruments as tracking stocks and certain venture capital funds. The model suggests that, while agency theory has focused on incentive compatibility, the often overlooked participation constraint can help explain many common compensation schemes.