Relative Wealth Concerns, Executive Compensation, and Managerial Risk-Taking†

This paper theoretically examines how relative wealth concerns affect equilibrium contracting and systemic risk-taking. We find that such externalities can generate pay for luck as an equilibrium strategy. In expectation of pay for luck in other firms, tying mana-gerial pay to luck provides insurance to managers against a com-pensation shortfall relative to executive peers. We also show that an effort-inducing mechanism exists: managers have additional incen-tives to exert effort in utilizing investment opportunities, which helps them keep up with their peers during industry movements; however, pay for luck that is efficient within firms can nonetheless exacerbate aggregate fluctuations, especially during periods of heightened mar-ket risk. (JEL D81, D82, D86, G51, M12, M52)