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Why Do Firms Use Incentives That Have No Incentive Effects?


  • Paul Oyer

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    • Oyer is with the Graduate School of Business, Stanford University. I thank George Baker, Kenneth Corts, Adlai Fisher, Robert Gibbons, Richard Green, Phanwadee Khananusapkul, Edward Lazear, Bentley MacLeod, Kevin J. Murphy, Canice Prendergast, James Rebitzer, Scott Schaefer, Andy Skrzypacz, Charles Thomas, Jan Zabojnik, a referee, and seminar participants at Harvard Business School, Northwestern, University of Rochester, University of Michigan, USC, the 2000 Stanford Personnel Economics Conference, the 2000 Econometric Society World Congress, the 2001 AEA Meetings, and the 2001 Western Finance Association meetings for helpful comments.


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 and where employees' outside opportunities are correlated with their firms' performance. The model may help to explain the use and recent rise of broad-based stock option plans, as well as other financial instruments, even when these pay plans have no effect on employees' on-the-job behavior. The model suggests that agency theory's often-overlooked participation constraint may be an important determinant of some common compensation schemes, particularly for employees below the highest executive ranks.

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