Dispersed Information and CEO Incentives∗

Abstract

This paper shows how the stock market’s capacity to aggregate dispersed informa-tion is connected to CEO incentives. In particular, I highlight several informational inefficiencies associated with giving the CEO stock-based compensation and thus discretion when choosing corporate investment. While this scheme leads to high effort provision in equilibrium, it suffers from amplified noise in the stock price and an excessive use of price information (relative to the constrained efficient bench-mark). As a result, stock prices under this compensation mechanism are excessively volatile and exposed to non-fundamental noise. I then compare this incentive struc-ture to a flat wage & fixed investment rule environment in which the firm owners specify an ex ante optimal rule for the CEO. It follows, that the equilibrium out-come demonstrates undistorted price efficiency, but no incentive for the CEO to invest in a profitable growth opportunity. I characterize conditions for the optimal compensation structure and show how a log-linear tax on the firm’s dividend can improve upon the equilibrium outcome