Can Agents Be Better Off with Pay Caps?

Abstract

A popular way to discipline the managers of companies or banks that got into trouble during the recent financial crisis has been to impose caps on managers' pay. Using a small extension of the standard principal-agent model, we argue that pay caps might serve the opposite purpose, because the agent might be better off with a pay cap. Specifically, we show that, given a fixed effort level to be implemented, the agent's expected utility can be decreasing in an upper bound for the agent's reward. The effect of pay caps on the general structure of optimal incentive contracts is also characterized. While an improvement of contracting information always helps the principal, it might increase or decrease the marginal cost of imposing pay caps.