How to Pay Envious Managers – a Theoretical Analysis

• Author: Marc Crummenerl,Christian Koziol,Tilmann Doll
• Date: 01 September 2015
• DOI: http://doi.org/10.1111/eufm.12044
• Published date: 01 September 2015

How to Pay Envious Managers –

a Theoretical Analysis

Marc Crummenerl

University of Tübingen, Department of Finance, Nauklerstraße 47,

72074 Tübingen, Germany

E-mail: marc.crummenerl@uni-tuebingen.de

Tilmann Doll

University of Hohenheim, Chair of Risk Management and Derivatives,

Wollgrasweg 23, 70599 Stuttgart, Germany

E-mail: tilmann.doll@gmail.com

Christian Koziol

University of Tübingen, Department of Finance, Nauklerstraße 47,

72074 Tübingen, Germany

E-mail: christian.koziol@uni-tuebingen.de

Abstract

This paper analyses how envy affects the decisions of competing managers and

their optimal stock-based compensation from the perspective of shareholder value.

We consider a typical framework in which managers can induce effort to reduce

production costs and make decisions regarding production volume. At first glance,

envy between managers from competing firms appears to be an unfavorable

characteristic because it does not align the interests of managers with those of

shareholders. However, our model finds that envy is a powerful incentive

mechanism. The model yields three key findings: (i) envious managers outperform

self-interested managers, (ii) firms optimally hire envious managers, and

(iii) shareholdersdo not grant any stock-based compensation toenvious managers.

Keywords: executive compensation, inequity aversion, cournot competition

JEL classification: D21, D63, J31, M52

We are grateful to John Doukas (the editor) for his valuable suggestions as well as two

anonymous referees for the in-depth comments, which significantly improved the paper.

We also thank participants of the GEABA conference Graz, DGF annual meeting

Hannover, Workshop Financial Markets & Risk Obergurgl and WHU campus for finance

for their helpful remarks.

European Financial Management, Vol. 21, No. 4, 2015, 811–832

doi: 10.1111/eufm.12044

© 2014 John Wiley & Sons Ltd

1. Introduction

Frequentmedia reports on the highestearning CEOs suggestthat bonuses and stockoptions

amount to a substantialfraction of executive compensation. According to classical results,

performance related pay is used to align manager incentives with those of shareholders

(see, forexample, Edmans and Gabaix(2009) for a survey of optimalcontracting theories).

However, being rewarded as an industry’s best paid manager might provide additional

utility beyond the increase in consumption. In the opposite case, a manager might feel

worse off if competingmanagers earn more despite all consumptionneeds being covered.

Thus,do classical compensationschemes still workwhen managers are envious?Do highly

paid but envious managers really act in the best interest of shareholders?And is there any

other –potentially negative –manager behavior induced by envy?

Social paradigms have received substantial attention in recent studies of executive

compensation and CEO turnover (see, for example, Goel and Thakor (2008),

Malmendier and Tate (2009), Maug et al. (2013), and Yermack (2006)). The goal of

this paper is to incorporate another social paradigm –envy –into a theoretical framework

of executive compensation and to derive an optimal compensation contract. In simple

terms, envy is the feeling of wanting something that someone else has (see, for example,

Smith et al., 1999). Malmendier and Tate (2009) propose that managers especially

concern themselves with compensation, status or press coverage. In addition, the envious

person has the desire to reduce this feeling of unhappiness. The fact that envy triggers a

counter-action makes its study particularly interesting in an economic context.

According to conventional wisdom, hiring an envious manager does not seem very

appealing. Envy results in a divergence between shareholders’and managers’objectives,

suggesting that envious managers might be worse managers. As a consequence, envious

managers would seem to require more stock-based pay relative to their self-interested

(non-envious) peers. This view is confirmed by Malmendier and Tate (2009) who

analyse the performance of superstar CEOs, who particularly care about social status and

prestige. They find that CEOs who win business awards exhibit underperformance

subsequent to the award, despite being paid more. Bouwman (2013) finds that the pay of

competing managers increases when their firms are located closer to each other. She

interprets the geographical distance between two firms’headquarters as a measure of

envy. However, there is also contradicting empirical evidence. For example, Maug et al.

(2013) argue that CEOs of prestigious firms listed among America’s most admired

companies earn less then their counterparts working for non-prestigious firms.

We contribute to the literature by combining three important elements: reciprocal

preferences in the form of envy (Fehr and Schmidt, 1999), strategic interaction through

product market competition and an analysis of optimal compensation contracts (as, for

example, studied by Fershtman and Judd (1987)). We consider a model with two

managers and two shareholders. Managers have an objective function that consists of

stock, effort and envy costs. Both managers find themselves in a classical Cournot

competition in which setting a high production quantity reduces the overall market price

for both players.

1

Envy has two major consequences. First, managers work harder and

1

Our main results regarding the employment of envious managers also hold in a Bertrand

price competition with heterogeneous goods. However, this alternate model of the market

requires additional constraints.

© 2014 John Wiley & Sons Ltd

812 Marc Crummenerl, Tilmann Doll and Christian Koziol