Compensation not only provides incentives to an existing manager but also affects the type of manager attracted to the firm. This paper examines the dual incentive and sorting effects of performance pay in a simple contracting model of endogenous participation. Unless the manager is highly risk averse, sorting dampens optimal pay-performance sensitivity (PPS) because PPS beyond a nominal amount transfers unnecessary (information) rent to the manager. This helps explain why empirical estimates of PPS are much lower than predictions from models of moral hazard alone. The model also predicts that sorting under asymmetric information causes the firm to turn away more candidates than would be efficient; PPS increases in the cost of hiring the manager and in the manager's outside option, but decreases in output risk, information risk, and managerial risk aversion; and the firm becomes more selective in hiring as either the manager's outside option, the cost of hiring, risk aversion, output risk, or information risk increases.
This paper was accepted by Mary Barth, accounting.