WHY DO FIRMS USE INCENTIVES THAT HAVE NO INCENTIVE EFFECTS?

by Paul Oyer

The Journal of Finance, 59, August 2004, 1619-1649.

ABSTRACT

This paper illustrates why firms might choose to implement stock option plans or other pay instruments that reward ``luck.'' I consider a model where adjusting compensation contracts is costly and where employees' outside opportunities are correlated with their firms' performance. The model may help explain the use and recent rise of broad-based stock option plans, as well as other financial instruments, even when these pay plans have no effect on employees' on-the-job behavior. The model suggests that agency theory's often overlooked participation constraint may be an important determinant of some common compensation schemes, particularly for employees below the highest executive ranks.