Some unpleasant general equilibrium implications of executive incentive compensation contracts

We consider a simple real business cycle model in which shareholders hire self-interested executives to manage their firm. A generic family of compensation contracts similar to those employed in practice is studied. When compensation is convex in the firm's dividend, an increase in the firm's output results in a more than proportional increase in the managers' income. Incentive contracts of sufficient yet modest convexity are shown to result in an indeterminate general equilibrium, one in which business cycles are driven by self-fulfilling fluctuations in managers' expectations. The proposed family of contracts may yield first-best outcomes for specific parameter choices. (C) 2012 Elsevier Inc. All rights reserved.