Sorting Effects of Performance Pay

Compensation not only provides incentives to existing managers but attracts new managers to the firm. This paper examines the dual incentive and sorting effects of performance pay in a simple contracting model of endogenous participation. The main result is that sorting dampens optimal pay-performance sensitivity (PPS). This occurs because PPS beyond a nominal amount transfers unnecessary rent from the firm to the manager. The result helps explain why empirical estimates of PPS are much lower than predictions from models of moral hazard alone. Finally, the model delivers a number of comparative statics that can be tested against data, predicting a web of relationship between PPS, the quality of the manager, the variation between managers, and the manager’s risk aversion and outside option. Thanks to Georgetown for financial support.