Incentives, CEO compensation, and shareholder wealth in a dynamic agency model

M. Jensen and K. Murphy (1990, J. Polit. Econ. 98, 225-264) argue that the observed pay-performance sensitivity of CEO compensation is too low to be consistent with formal agency theory. This paper uses a dynamic agency model to offer a resolution of the Jensen and Murphy puzzle. We show that the dynamic agency model can predict either a positive or a negative pay-performance sensitivity, depending on the parameter values of the model and the distribution of the CEOs' initial expected discounted utilities. For a large variety of parameter values and for properly chosen distributions of initial CEO expected discounted utilities, our model is capable of generating data where the pay-performance sensitivity is significantly positive but very small, as in Jensen and Murphy's data. The key to our result is a compensation rigidity that is created endogenously by the optimal dynamic contract. (C) 1997 Academic Press.