What Form of Relative Performance Evaluation?

Abstract

We study relative performance evaluation in executive compensation when executives have private information about their ability. We assume that the joint distribution of an individual firm s profit and market movements depends on the ability of the executive that runs the firm. In the equilibrium of the executive labor market, compensation schemes exploit this fact to sort executives of di ?erent abilities. This implies that executive compensation is increasing in own performance, but may also be increasing in industry performance-a sharp departure from standard relative performance evaluation. This result provides an explanation for the scarcity of relative performance considerations in executive compensation documented by the empirical literature.