Beauty Contests, Market-Based Compensation, and Reporting Quality

Abstract

Market-based incentive pay is widely used in managerial compensation. In this study, we examine how Keynesian beauty contests and higher-order beliefs among investors affect the market-based performance measures used by a firm, as well as (1) the optimal compensation contract between the firm's owner and manager, and (2) the owner's choice of reporting quality. Compared to the benchmark without beauty contests, if the investors' decisions are strategic complements (substitutes), beauty contests in the financial market result in more (less) volatile performance measures used to evaluate the manager and decreased (increased) use of market-based compensation in equilibrium. Contingent on the type of the market, the owner can choose a reporting quality to maximize the firm value. Specifically, the reporting quality chosen by the owner is lower (higher) when the investments are strategic complements (substitutes). Further, since the investors have their source of private information, the owner never chooses the highest level of precision for the firm's accounting reports. However, the owner's choice of reporting quality is indeed socially optimal, as it also serves to minimize the deviation of the market's aggregate investment from the firm's fundamental value and thus reduce the chance of asset bubbles.

Keywords: Beauty contest, higher order beliefs, market-based compensation, reporting quality.

JEL Classification: M40, M12