Competition for Talent Under Performance Manipulation: CEOs on Steroids

Abstract

We study how competition for talent affects CEO compensation, taking into consideration that CEO decisions and CEO skills or talent are not observable, and CEOs can manipulate performance as measured by outsiders. Firms compete by offering contracts that generate rents for the CEO. We derive the equilibrium compensation contract, and we describe how competition changes that contract and the outcome. Intuitively, competition increases realized CEO compensation. It also strengthens the incentive power of the contracts. While competition mitigates inefficiencies caused in its absence, it also generates inefficiencies of its own. Competition replaces a downward distortion by an upwards distortion (incentive power is excessively strong), and it switches the focus of equilibrium effort distortions from low-talent CEOs to high-talent CEOs. Competition leads to higher effort but also to more manipulation of measured performance. If the cost of manipulating performance is low, the distortions can outweigh those that are mitigated, and competition for talent may reduce the overall surplus. We discuss possible remedies, including regulatory limits to incentive compensation.