Discussion Paper No . 486 Managerial Incentive Problems and Return Distributions

We study a model of managerial incentive problems where a manager chooses the …rst two moments of his …rm’s pro…t distribution mean and volatility along an e¢ cient frontier. Assuming that managers di¤er with respect to their marginal cost of e¤ort and their risk aversion we explore our model’s comparative statics predictions in full detail. If managers’preference parameters are commonly known and associated, then a positive correlation between expected returns, volatility of pro…ts, and incentives is the natural outcome. Allowing in addition for adverse selection with respect to the managers’ preference parameters does not change the predicted correlation if the variation in observed contracts is not too large. Moreover, observed incentive schemes re‡ect exclusion of some manager types. Neglecting the endogeneity of risk in empirical studies biases estimates towards zero. JEL Classi…cation: D82, J33 Keywords: Managerial incentive problems, comparative statics, multidimensional heterogeneity, multidimensional screening We would like to thank seminar audiences at the University of Bonn, Frankfurt, Rotterdam, Napels, Pompeu Fabra and an SFB-conference meeting where previous versions of this paper were presented. Many thanks in particular to Helmut Bester, Nina Bobkova, Jörg Budde, Inga Deimen, Armin Falk, Guido Friebel, Martin Hellwig, Ian Jewitt, Matthias Kräkel, Salvatore Piccolo, and Klaus Schmidt. Venuga Yokeeswaran acknowledges …nancial support through a doctoral grant by the DFG. ySend communications to szalay@uni-bonn.de or by ordinary mail to Dezsö Szalay, Institute for Microeconomics, University of Bonn, Adenauerallee 24-42, 53113 Bonn, Germany.