Why Do Firms Use Incentives That Have No Incentive Effects?

This paper illustrates why firms might choose to implement stock option plans or other pay instruments that reward “luck.” I consider a model where adjusting compensation contracts is costly (or wages are rigid) and where agents’ outside opportunities are correlated with their firms’ performance. I derive conditions under which firms will pay based on firm performance, even when such pay schemes have little or no effect on agents’ on-the-job behavior. I derive implications of the model and discuss how it may help explain the use and recent rise of broad-based stock option plans, profit sharing, and the lack of indexing in executive compensation contracts. The model can also help explain the popularity of such financial instruments as tracking stocks and certain venture capital funds. The model suggests that, while agency theory has focused on incentive compatibility, the often overlooked participation constraint can help explain some common compensation schemes.