The relationships among managerial discretion, firm performance, and chief executive officer compensation: A simultaneous equations system approach

Abstract

Prior executive compensation studies overlooked the endogeneity of firm performance and the simultaneity of managerial discretion, firm performance, and CEO pay. To overcome these two shortcomings, we propose a novel simultaneous equations system model to investigate the cause-and-effect relationships among research & development (R&D), advertising, firm performance, and CEO compensation, which are jointly affected by CEO's tenure, age, ownership, firm size, risk, and industry. Although the feedback loops are positive between firm performance and CEO pay and between advertising and firm performance, the feedback loop is negative between R&D and firm performance. Firm size has a direct and indirect effect on R&D, advertising, firm performance, and CEO pay. Large firm size may entice CEOs to invest excessively in R&D, leading to poor performance and low pay. Our study implies that the positive relationship between firm performance and CEO pay depends upon the appropriateness of the strategic choices that CEOs make.