Risk Aversion, Performance Pay, and the Principal-Agent Problem

This paper calculates numerical solutions to the principal-agent problem andcompares the results to the stylized facts of CEO compensation. The numericalpredictions come from parameterizing the models of Grossman and Hart and of Holmstrom and Milgrom. While the correct incentives for a CEO can greatly enhance a firm’s performance, providing such incentives need not be expensive. For many parameter values, CEO compensation need only increase by about $10 for every $1,000 of additional shareholder value; for some values, the amountis 0.003 cents. The paper thus answers two challenges posed by Jensen: that principal-agent theory does not yield quantitative predictions, and that CEO compensation is insufficiently sensitive to firm performance.