NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Optimal Incentive Contracts in the Presence of Career Concerns: Theory and Evidence

Robert Gibbons, Kevin J. Murphy

NBER Working Paper No. 3792 (Also Reprint No. r1746)
Issued in September 1992
NBER Program(s):   LS

This paper studies career concerns -- concerns about the effects of current performance on future compensation -- and describes how optimal incentive contracts are affected when career concerns are taken into account. Career concerns arise frequently: they occur whenever the market uses a worker's current output to update its belief about the worker's ability and competition then forces future wages (or wage contracts) to reflect these updated beliefs. Career concerns are stronger when a worker is further from retirement, because a longer prospective career increases the return to changing the market's belief. In the presence of career concerns, the optimal compensation contract optimizes total incentives -- the combination of the implicit incentives from career concerns and the explicit incentives from the compensation contract. Thus, the explicit incentives from the optimal compensation contract should be strongest when a worker is close to retirement. We find empirical support for this prediction in the relation between chief-executive compensation and stock-market performance.

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Published: Journal of Political Economy, Vol. 100, No. 3, pp. 468-505, (June 1992).

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