Can Agents Be Better Off with Pay Caps?

Abstract

Imposing caps on managers' pay has been a popular way to discipline managers of companies or banks that got into trouble during the recent financial crisis. Using a small extension of the standard principal-agent model, we argue that pay caps may serve the opposite purpose because the agent can be better off with a pay cap. Specifically, we show that, given a fixed effort level to be implemented, the agent's expected utility can be decreasing in an upper bound for the agent's reward. The model also offers a characterization of the effect of pay caps on the general structure of optimal incentive contracts.While improvement of contracting information always helps the principal, it may increase or decrease the marginal cost of imposing pay caps.