Executive compensation remains one of the most contentious topics in finance. The debate is usually polarized between two views. On one side, the “shareholder view” argues that high pay is an efficient market outcome—the necessary price for scarce talent in a competitive world. On the other side, the “managerial power view” argues that high pay is the result of rent extraction by entrenched CEOs taking advantage of weak boards.

In our recent paper, Too Much, Too Soon, for Too Long: The Dynamics of Competitive Executive Compensation (Journal of Finance, 2025), we propose a novel perspective. We show that even when boards are perfectly independent and markets are perfectly competitive, the equilibrium CEO compensation package is inefficient.

Specifically, we find that in a competitive market, executives are paid too much, receive their pay too soon, and keep their jobs for too long relative to what is socially optimal.

The Mechanism: Externalities through Outside Options

Why does competition lead to inefficiency? The answer lies in pecuniary externalities, the ripple effects that one firm’s contract choices have on the wider labor market via the outside options available to corporate executives.

To understand this, consider how a board designs a compensation package. To align the CEO’s interests with those of shareholders, the board uses performance-based pay that combines two primary tools:

1. “Carrots”: promised compensation that is paid with delay following good performance.
2. “Sticks”: the threat of termination following poor performance.

The effectiveness of the “stick” depends entirely on what happens to the CEO after they are fired. If the CEO faces a long period of unemployment or a significant pay cut in their next job, the threat of termination is a powerful incentive to work hard. However, if the CEO can easily land a lucrative position at another firm, the threat of termination loses its bite.

This is where the externality arises. When a firm chooses a generous compensation package for its own CEO to maximize its own shareholder value, it inadvertently improves the outside option for CEOs at other firms. It effectively raises the safety net for every other executive in the market.

The Consequence: A Weaker Threat and Higher Costs

Individual boards fail to internalize this spillover effect. When they design their contracts, they take the market conditions as given. They do not account for the fact that their generous pay packages contribute to a market environment where the “threat of termination” is critically weakened.

A social planner, who designs pay packages to maximize shareholder value in the entire economy, would choose a lower level of compensation. By coordinating to lower the value of outside options, the planner would restore the “bite” of the termination threat, allowing firms to incentivize CEOs more efficiently with lower pay, more deferral, and more disciplined turnover. By contrast, in the laissez-faire economy, where the outside options are now better, the “stick” (firing) becomes a less effective incentive device. To compensate for this weaker stick, firms are forced to rely more heavily on “carrots.” This dynamic drives the three main distortions:

1. Too Much: To provide sufficient incentives without a credible termination threat, firms must offer significantly higher levels of compensation.
2. Too Soon: Because promising massive future rewards is expensive (CEOs are impatient), firms end up front-loading payments rather than deferring them optimally.
3. Too Long: With termination rendered less effective by high outside options, boards fire CEOs less frequently than a social planner would.

The severity of these distortions can vary across industries and over time. They are more pronounced in sectors where executives are highly mobile, and their skills are easily transferable across firms. In such industries, managers face low termination costs and can quickly secure attractive outside opportunities, weakening the disciplinary role of dismissal and pushing firms to rely more heavily on high and front-loaded compensation. Distortions are also more severe in industries where replacing top management is especially costly or disruptive, making boards reluctant to fire underperforming CEOs. Finally, sectors characterized by greater moral hazard or more volatile cash flows—where performance is harder to evaluate—are particularly susceptible. In these sectors, firms’ compensation packages feature higher pay, less deferral, and greater job security.

A natural tool to ameliorate this externality is contractual restrictions that limit managers’ outside options, such as noncompete clauses. By reducing executives’ fallback opportunities, noncompetes can restore the effectiveness of termination as an incentive device and help curb overcompensation. However, despite their appeal, they come with a caveat: noncompetes also impose a negative externality on other firms by restricting their ability to hire managerial talent.

Conclusion

Our findings suggest that excessive executive pay may not be solely due to CEOs capturing boards. Rather, competitive pay can lead to inefficiencies in compensation packages. These inefficiencies are the result of a coordination failure. Because individual boards fail to account for the externalities their own pay packages impose on the effectiveness of termination threats for others, firms can end up paying their CEOs too much, too soon, for too long, even in the absence of corporate governance failures.