Sticks or Carrots? Optimal CEO Compensation when Managers Are Loss Averse

This paper analyzes optimal executive compensation contracts when managers are loss averse. We calibrate a stylized principal‐agent model to the observed contracts of 595 CEOs and show that this model can explain observed option holdings and high base salaries remarkably well for a range of parameterizations. We also derive and calibrate the general shape of the optimal contract that is increasing and convex for medium and high outcomes and that drops discontinuously to the lowest possible payout for low outcomes. Finally, we identify the critical features of the loss‐aversion model that render optimal contracts convex.     

The Optimal Use of Fines and Imprisonment If Governments Do Not Maximize Welfare

We consider a stylized model of crime and punishment in which the prosecution policy is defined by three variables: the size of punishment, the type of punishment, and the detection probability. We derive the optimal type of punishment under the assumption that the detection probability is chosen by a government whose objective function places a higher weight on the government's budget than the social welfare function does. We show that for serious crimes exclusive imprisonment is welfare maximizing. If costs of imprisonment are taken into account, the optimal punishment is a prison term with an additional fine that is smaller or equal to the costs of the prison term. For less serious crimes, fines without imprisonment are welfare maximizing. Therefore, this paper demonstrates that the standard result of the literature that fines should be used whenever feasible need not hold in the presence of a rent‐seeking government. Moreover, it offers a new explanation for the widespread use of mandatory imprisonment for serious crimes.     

Lower Salaries and No Options? On the Optimal Structure of Executive Pay

We calibrate the standard principal–agent model with constant relative risk aversion and lognormal stock prices to a sample of 598 U.S. CEOs. We show that this model predicts that most CEOs should not hold any stock options. Instead, CEOs should have lower base salaries and receive additional shares in their companies; many would be required to purchase additional stock in their companies. These contracts would reduce average compensation costs by 20% while providing the same incentives and the same utility to CEOs. We conclude that the standard principal–agent model typically used in the literature cannot rationalize observed contracts.