The Link Between CEO Compensation and Firm Performance: Does Simultaneity Matter?

In order to combat the principle-agent problem, directors of public companies use incentive-based contracts to align the interests of CEOs and shareholders. Some studies suggest that these contracts are an inefficient use of resources, and that they do not motivate CEOs to do what is best for the firm. In this study, the author estimates a regression to find the relationship between CEO Compensation and market value of a firm. In order to address persistence, endogeneity and firm-specific effects the author uses the first-differenced and system GMM regression techniques first used by Arellano, M.; Bover, O. “Another Look at the Instrumental-Variable Estimation of Error-Component Models,” Journal of Econometrics, 68, 1995, pp. 29–51] and Blundell, R. W.; Bonds, S. R. “Initial Conditions and Moment Restrictions in Dynamic Panel Data Models,” Journal of Econometrics, 87, 1998, pp. 115–43; Blundell, R. W.; Bond, S. R., Windmeijer, F. “Estimation in Dynamic Panel Data Models: Improving on the Performance of the Standard GMM Estimators,” Institute for Fiscal Studies Working Paper W00/12, London, England, 2000]. These regressions report a positive relationship between CEO compensation and market value of a firm. This study concludes that incentive based contracts are effective, due to the positive pay-to-performance link, when controlling for simultaneity. First place winner of the Undergraduate Best Paper Award Competition at the 60th International Atlantic Economic Conference in New York, NY, October 6–9, 2005.