The ‘Pay for Luck’ Puzzle: A Macroeconomist’s View

Abstract

The present study considers a model of delegated management where risk-averse shareholders delegate their firm’s management to self-interested executives/ managers, but within the general equilibrium context of Pigouvian cycles. A socially optimal class of managers’ renumeration contracts is identified in this Pigouvian environment where business fluctuations could be driven by private-sector expectations that are unrelated to economic fundamentals. These general equilibrium considerations have two primary implications. First, the “pay-for-luck” phenomenon, largely emphasized in the executive compensation literature, arises as an aggregate equilibrium outcome, thereby providing a corollary resolution of the corresponding “pay-for-luck” puzzle. While rendering the CEO-to-worker pay ratio essentially irrelevant to social welfare, the delegated management economy with the manager’s first-best compensation contracts may produce economy-wide welfare losses more than one order of magnitude larger that the Lucasian cost-of-business-cycle estimate, which constitutes a second point.