1. © 2008 Robert H. Smith School of Business University of Maryland A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium By Edmans, Gabaix, and Landier (RFS 2009) Presented by Ben Munyan and Danmo Lin

2. © 2008 Robert H. Smith School of Business University of Maryland Main Ideas of the Paper Theory: Applies assignment model from matching theory to CEO labor market Predictions: –CEO compensation should vary with size of firm –CEO compensation structure should be the same across firms (incentives level)

3. © 2008 Robert H. Smith School of Business University of Maryland Main Ideas of the Paper Empirical Evidence: Use Compustat merged with Execucomp (1992-2006) to test their predictions about CEO Compensation

4. © 2008 Robert H. Smith School of Business University of Maryland The Model Key idea of paper: multiplicative preferences, multiplicative effects of CEO talent and effort on firm performance Versus: Additive preferences, additive actions of CEOs to firm performance

5. © 2008 Robert H. Smith School of Business University of Maryland The Model

6. © 2008 Robert H. Smith School of Business University of Maryland The Model

7. © 2008 Robert H. Smith School of Business University of Maryland The Model CEO Compensation c is assumed to have 2 parts: cash salary and equity stake:

8. © 2008 Robert H. Smith School of Business University of Maryland Theoretical Results

9. © 2008 Robert H. Smith School of Business University of Maryland More on the Model: Gabaix & Landier model added Talent assignment model (a la Shapley & Shubik) Continuum of firms and continuum of CEO talents  matching where n th largest CEO is matched to n th largest firm and paid

10. © 2008 Robert H. Smith School of Business University of Maryland Theoretical Results II

11. © 2008 Robert H. Smith School of Business University of Maryland Overview of Theoretical Results Basically solved for CEO incentives pay structure (salary vs equity), then solved for the endogenous amount of total wages.

12. © 2008 Robert H. Smith School of Business University of Maryland What’s Really New Define a “new” pay-performance sensitivity measure b I, and show an invariance result with it:

13. © 2008 Robert H. Smith School of Business University of Maryland

17. Empirical Evaluation Evaluate two main things: –Determinants of CEO incentives Really the elasticities of wealth-performance sensitivities with firm size. (The invariance scaling prediction) –The level of CEO incentives Calibrate a model to estimate the level of incentives offered to CEO, and decide whether they are enough to preclude shirking

18. © 2008 Robert H. Smith School of Business University of Maryland Empirical Results

19. © 2008 Robert H. Smith School of Business University of Maryland Empirical Results II

20. © 2008 Robert H. Smith School of Business University of Maryland Conclusion The CEO’s low fractional ownership and its negative relationship with firm size can be quantitatively reconciled with optimal contracting in a multiplicative model, and need not reflect rent extraction The dollar change in wealth for a % change in firm value, divided by annual pay, is independent of firm size, and therefore a desirable empirical measure of incentives –i.e. invariance result means this is a useful measure to control for size effects Incentive pay is effective at solving agency problems with multiplicative impacts on firm value, such as strategy choice. –But not additive actions, such as the use of perks

21. © 2008 Robert H. Smith School of Business University of Maryland Thank you!