I study the joint choice of responsibility assignment, performance measures, and rewards for a two-stage process where the quality of the initial stage work affects the required final stage effort. By assigning responsibilities to give the initial stage agent an incentive to sabotage the final stage, output is made informative about this agent's attention to quality. I find conditions under which it is cost-effective to create and to contractually use such information. This analysis makes formal that the value of a performance measure is determined not simply by its congruity and precision but by its influence on the optimal organisational design.

For a two-stage production process, two assignments of tasks among two agents are studied: an ‘assembly line’, where each agent is responsible for one stage, vs. a ‘team’, where agents are jointly responsible for all tasks. When attention paid to quality at the initial stage affects the final-stage task, the team approach is optimal for unsophisticated production technology. As technology improves, the assembly line becomes dominating while continued improvements eventually makes it optimal to abandon the assembly line again in favor of the team approach. When such switches in job design occur, the optimal investment in technology exhibits positive jumps.

This paper demonstrates that options can be used to eliminate agency costs in the formal agency model. When an agent's action can determine the mean of future cash flows assumed to follow a binomial random walk, the principal can design a compensation package using options which are hedged by other components of the compensation package to be risk-free only if the agent takes the action desired by the principal and therefore risky if the agent is shirking. Thus, a risk- (and effort-) averse agent can be given incentives to take the action desired by the principal without sacrificing optimal risk sharing, even when the agent's action cannot be observed, either directly or indirectly.

We provide an informational theory for how the ownership claims to a firm might be structured. When the market price of equity provides valuable contracting information there is a benefit to creating separate ownership claims to each of a firm's divisions. However, creating this information also generally has adverse incentive effects because it enriches the agent's strategy space. We show in a complete contracting setting that under a large class of agencies the firm is strictly better off bundling the ownership claims to divisions that are sufficiently similar and creating separate ownership claims only to divisions that are sufficiently different.

We study how friendly boards design the structure of optimal compensation contracts in favor of powerful CEOs. Our study yields unexpected results. First, powerful managers receive higher pay and a contract with a higher pay-performance sensitivity (PPS) if firm performance is low and vice versa. Moreover, we identify conditions where expected pay and expected PPS are both increasing in the friendliness of the board. Second, we show that friendly boards provide managers with higher salaries, more shares, but less options. Third, friendly boards offering contracts with a higher PPS also make more intensive use of relative performance evaluation (RPE). Overall, our results suggest that frequently used indicators of poor (or sound) compensation practices should be interpreted with care. Extending the scope of our model beyond executive pay, we show that powerful managers underinvest in capital but have less incentives to manage earnings.

We study when it is appropriate to add a convex component such as stock options to an optimal, managerial compensation contract. We show that convexity is introduced when managers have moderate levels of relative risk aversion and decreasing absolute risk aversion. In addition, we study how convexity is affected as the distribution of outcomes becomes more skewed toward low outcomes. Here we show that while convexity increases when skewness is increased without regard to the effect on mean stock price, the opposite effect results when increases in skewness leave the mean stock price unchanged.

This paper examines the exercise of employee stock options (ESOs) by executive officers. We document a positive relation between the variance of ESO returns and the remaining life of the option at exercise, and show that the strength of the relation is reduced by the extent the firm hedges the returns on the ESO. We thus provide empirical evidence of a link between an ESO's expected term and its investment risk to the executive, and document that some firms provide a hedge against option risk.