Fair and Square: a Theory of Managerial Compensation

Abstract: We propose a new model of managerial compensation contracts. Once employed, a risk-averse manager acquires imperfectly portable skills whose value is stochastic due to industry-wide demand shocks. The manager's actions are not contractible, and the perceived fairness of the compensation contract affects the manager's motivation. If the volatility of profits is sufficiently large and outside offers are sufficiently likely, the equilibrium contract combines a salary with an own-firm stock option. The model's predictions are consistent with empirical regularities concerning contractual shape, the magnitude of variable pay, the lack of indexation, and the prevalence of discretionary severance pay.