Why Do Firms Use Incentives That Have No Incentive Effects?

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SIEPR Discussion Paper 02-006

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Published:

12/1/02

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Abstract:

This paper illustrates why firms might choose to implement stock option plans or other pay instruments that reward “luck.” I consider a model where adjusting compensation contracts is costly and where employees’ outside opportunities are correlated with their firms’ performance. The model may help explain the use and recent rise of broad-based stock option plans, as well as other financial instruments, even when these pay plans have no effect on employees’ on-the-job behavior. The model suggests that agency theory’s often overlooked participation constraint may be an important determinant of some common compensation schemes, particularly for employees below the highest executive ranks.