European Financial Management , Vol. 4, No. 3, 1998, 335–360 Contestability and pay differential in the executive suites James S. Ang Department of Finance, College of Business, Florida State University, Tallasassee, Florida 32306-1042 e-mail: jang@cob.fsu.edu Shmuel Hauser Israel Security Authority and Ben-Gurion University, Israel and Beni Lauterbach Bar-Ilan University, Israel Abstract In comparison to the abundant evidence on CEOs’ compensations, little is known about the compensation of other senior executives, and on how the pay differential between CEO and other senior executives affects firm performance. We examine several potential explanations of the pay differential in the execu- tive suite, using a sample of 367 Israeli firms listed on the Tel-Aviv Stock Exchange. The empirical results fail to support the tournament and pay equity models. Instead, our evidence suggests a model where senior executives are encouraged (by the structure implied in their pay contract) to cooperate with each other (the team playing model). In a subset of firms managed by their owners we observe greater pay differentials between the owner-CEO and other senior executives. Interestingly, only in this subset of owner-managed firms, higher pay differentials can be associated with better firm performance. Keywords: executive compensation, organisational structure, tournaments. JEL classification: G 32, J31, L 2. 1. Introduction In recent years, there has been a considerable amount of research on the compensations of top executives (Jensen and Murphy, 1990; Kaplan, 1994a, 1994b). The importance of this line of inquiry is well justified as incremental shareholders’ wealth may be created from an optimal compensation design. However, the research emphasis so far is on designing the package of compensa- tions for the top executives only. A neglected issue is the design of pay for other members of the top management team vis-` a-vis the CEO, or the optimal pay © Blackwell Publishers Ltd 1998, 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA