Very few business topics attract as much public attention as the paychecks of top executive officers in the largest U.S. companies. Undoubtedly, part of this interest has been fueled by the large and continuous increases in chief executive officers ’ (CEOs) compensation over the past three decades. Even ignoring the more recent escalation in the use of executive stock options (Brian Hall and Kevin J. Murphy, 2000, 2003), the base salaries and bonuses of Forbes 800 CEOs increased from an average of $700,000 in 1970 (in 2002-constant dollars) to over $2.2 million in 2000. 1 During the same period, the ratio of CEO cash compensation to average pay for production workers increased from about 25 in 1970 to nearly 90 in 2000. 2 The most prevalent explanation in popular press for this trend is the “fat cat ” theory, a variant of which has been espoused among academics by Lucian Bebchuk, Jesse Fried, and

Although exercise prices for executive stock options can be set either below or above the grant-date market price, in practice virtually all options are granted at the money. We offer an economic rationale for this apparent puzzle, by showing that pay-to-performance incentives for risk-averse undiversified executives are typically maximized by setting exercise prices at (or near) the grant-date market price. We provide an operationally useful alternative to Black-Scholes (1973) for the purpose of both valuing executive stock options and measuring the incentives created by options. Our framework has implications not only for exercise-price policies, but also for indexed options, option repricings, exchanges of cash for stock-based compensation, and the design of bonus plans.

Academics, consultants, and practitioners have long advocated bringing the market inside the firm. For example, in the 1950s and 1960s economists proposed that the transfer-pricing problem should be solved by charging market prices for internal transactions. Similarly, in the 1980s, financial economists suggested that the capital-allocation problem should be solved by charging the external cost of capital for internal investments. And wave after wave of organizational restructuring has advocated radical decentralization, empowerment, “intrapreneurship, ” and the like—in short, making employees feel like owners. Proponents of making transactions within firms more market-like often seem to ignore the factors that brought these transactions inside firms in the first place. But Bengt Holmstrom and Paul Milgrom (1991, 1994), Holmstrom and Jean Tirole (1991), and Holmstrom (1999) [hereafter collectively HMT] remind us that in some cases integration is efficient precisely because it eliminates market incentives. In such cases, bringing the market inside the firm would clearly be undesirable. In this paper we show that bringing the market inside the firm is often not feasible, even if it would be desirable. More precisely, if some aspects of the market transaction are non-contractible (as we define below) then it is impossible to replicate spot-market payoffs inside a firm. This result would be trivial if the firm’s only instruments were court-enforceable contracts: it is impossible (by definition) for such contracts to replicate payoffs that were non-contractible in a spot market. Our