A simple explanation of the relative performance evaluation puzzle

We study a simple moral hazard model in which two risk-neutral owners establish incentives for their risk-averse managers to exert effort. Because the probability distributions over output realizations depend on a common aggregate shock, optimal contracts make the compensation of each manager contingent on own performance but also on a performance benchmark—the performance of the other firm. If the marginal return of effort depends on the aggregate state, optimal contracts are not monotonically decreasing in the performance benchmark. This provides a simple explanation of the Relative Performance Evaluation (RPE) Puzzle—the documented lack of a negative relationship between CEO compensation and comparative performance measures, such as industry or market performance. Our simple model can also explain one-sided RPE—the documented tendency to insulate a CEO's rewards from bad luck, but not from good luck. We clarify that our results are robust in several dimensions and we discuss other applications of our findings.Marco Celentani acknowledges the financial support of Fundación BBVA. Marco Celentani and Rosa Loveira acknowledge the financial support of project BEC2002-03715 of Ministerio de Ciencia y Tecnología and of project SEJ2005-08462 of Ministerio de Educación y CienciaPublicad