Relative Performance Evaluation for Chief Executive Officers


Measured individual performance often depends on random factors which also
affect the performances of other workers in the same firm, industry, or market. In
these cases, relative performance evaluation (RPE) can provide incentives while
partially insulating workers from the common uncertainty. Basing pay on relative
performance, however, generates incentives to sabotage the measured performance of
co-workers, to collude with co-workers and shirk, and to apply for jobs with inept
co-workers. RPE contracts also are less desirable when the output of co-workers is
expensive to measure or in the presence of production externalities, as in the case of
team production.
The purpose of this paper is to review the benefits and costs of RPE and to test
for the presence of RPE in one occupation where the benefits plausibly exceed the
costs: top-level management. Rewarding chief executive officers (CEOs) based on
performance measured relative to the industry or market creates incentives to take
actions increasing shareholder wealth while insuring executives against the vagaries
of the stock and product markets that are beyond their control. We expect RPE to be
a common feature of implicit CEO compensation and dismissal contracts because the
potential benefit of filtering out common uncertainty is high, the cost of measuring the
performance of other firms is small, and opportunities for sabotage and collusive
shirking are limited.
In contrast to previous research, our empirical evidence strongly supports the
RPE hypothesis-—CEO pay revisions and retention probabilities are positively and
significantly related to firm performance, but are negatively and significantly related
to industry and market performance, ceteris paribus. Our results also suggest that
CEO performance is more likely to be evaluated relative to aggregate market
movements than relative to industry movements.

Year of Publication
Date Published
Publication Language
Citation Key
Industrial and Labor Relations Review, Vol. 43, No. 3, February 1990.
Working Papers