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E-MailThis post comes from Robert A. Miller and George-Levi Gayle of Carnegie Mellon University.
In our recently accepted American Economic Review paper entitled Has Moral Hazard Become a More Important Factor in Managerial Compensation? we estimate a model of moral hazard with data spanning a sixty-year period in order to investigate how well two specific channels explain secular changes in managerial compensation and to assess their relative importance. First, contracts reflect heterogeneity across firms, such as their size, capital-labor ratios, the sectors they belong to, and the dispersion of their financial returns. Consequently, changing the heterogeneity across firms induces changes in the aggregate level and variability of compensation. Second, the optimal contract is a function of the preferences and risk attitudes of managers. Changing those preferences also affects the probability distribution of compensation across executives.
The data for our empirical analysis are drawn from two samples that collectively span approximately sixty years from 1944 with a fifteen year break at 1978. The firms and their managers are selected from three industrial sectors, aerospace, chemicals, and electronics, broadly representative of all publicly traded corporations. Our empirical framework accommodates changes in the processes determining firm size and returns by separately estimating models of managerial compensation for the two samples and by parametrically allowing for the effects of changes on the contracts within each sample.
The welfare cost of the moral hazard is a compensating differential paid to risk-averse managers to hold insider wealth and accept non-diversifiable risk that realigns their incentives to those of the stockholders, who do not price risk from an individual firm’s abnormal returns because of their portfolio choices. We find that the welfare cost of the moral hazard associated with employing CEOs has increased by an estimated factor of more than twenty times in the aerospace and electronics sectors and six fold in the chemicals sector. Subtracting the welfare costs of the moral hazard from the expected compensation paid to top executives, we obtain, for each of the six categories, the average certainty equivalent wage which equates the supply and demand for managerial services for a given firm. The overall increase in the sixty year period is 2.3, the same as the increase in national income. Therefore our results attribute all the difference between the rate of increase in managerial compensation and the rate of increase in national income to the rising welfare cost of the moral hazard. We find the main reason this welfare cost steeply rose, is that large firms pay a higher risk premium than small firms to align the incentives of managers with their shareholders, and average firm size increased significantly over this period.
The full paper is available for download here.
