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Working Paper

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

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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.
12.01.1991ISSN 2573-7953 WP 91-18DOI 10.26509/frbc-wp-199118

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

Haubrich, Joseph G. 1991. “Risk Aversion, Performance Pay, and the Principal-Agent Problem.” Federal Reserve Bank of Cleveland, Working Paper No. 91-18. https://doi.org/10.26509/frbc-wp-199118