Introduction

Standard executive compensation models assume CEOs value pay solely for consumption, implying that bonuses must exceed the marginal cost of effort to motivate performance. However, recent surveys of directors and investors indicate that fairness concerns significantly influence pay setting; CEOs expect to be treated fairly and rewarded for firm value increases, even if driven by luck. This research bridges the gap between theoretical models and practice by introducing fairness concerns. It argues that firms do not always pay fair wages but instead utilise the threat of unfair wages (paying zero) to induce effort. This approach rationalises common market practices, such as performance-vesting equity and pay-for-performance, even in scenarios where traditional incentive arguments would suggest otherwise.

The model

The research modifies the standard principal-agent model by incorporating a fairness component into the agent’s utility function. The CEO believes they deserve a perceived ‘fair wage’, defined as a specific share of output. If the actual wage falls below this threshold, the CEO suffers disutility proportional to the discrepancy (represented by the parameter $\gamma$). Conversely, if the wage meets or exceeds the fair share, utility is linear. The principal is risk-neutral, and both parties operate under limited liability. This framework allows for an analysis of how fairness concerns—specifically the desire to avoid the disutility of underpayment—can be leveraged alongside consumption utility to motivate executive effort.

Analysis

The optimal contract derived from this model contrasts significantly with standard risk-neutral predictions, such as Innes (1990), which suggest a ‘live-or-die’ contract where pay jumps from zero to 100% of output. Instead, this analysis demonstrates that efficient contracts feature a milder discontinuity.

Performance-Vesting Equity: The optimal structure involves paying the CEO zero if output falls below a certain threshold (maximum unfairness to punish low performance) and the ‘fair wage’ if it exceeds it. This mirrors real-world performance-vesting equity, where shares are forfeited upon poor performance.

The Threat of Unfairness: Unfairness acts as a powerful motivator. By threatening the CEO with zero pay for low output, the firm effectively induces effort because the CEO works to avoid the disutility associated with an unfair wage.

Incentives ‘For Free’: When ensuring participation requires paying fair wages over a range of outputs, the firm creates incentives as a by-product. Since the fair wage naturally increases with output, the CEO is motivated to increase firm value to raise their fair wage, allowing the firm to induce effort without incurring additional incentive costs.

Conclusion

The study concludes that fairness concerns justify the use of performance thresholds and variable pay structures commonly seen in executive contracts. Unlike traditional models that predict extreme outcomes (paying the entire output), this theory supports the use of performance-vesting equity where pay jumps from zero to a proportionate fair share. Furthermore, it highlights that pay-for-performance may not always be intended to induce effort but rather to attract CEOs with fairness concerns or to satisfy the participation constraint efficiently. By aligning pay with the CEO’s perceived fair share of output, firms can rationalise incentive structures even for intrinsically motivated agents.