Job market paper
CEOs are rarely fired. This fact, often attributed to entrenchment, may adversely impact managerial incentives; entrenched CEOs can advance their private interests at shareholders' expense while facing little risk of disciplinary termination. In this paper, I estimate a dynamic principal-agent model to assess the impact of entrenchment on managerial incentives. Firms hire CEOs of unknown quality and subsequently design the optimal compensation contract. Firms gradually learn about CEO quality and make replacement decisions based on their beliefs. CEOs are entrenched, so replacement is costly. The threat of termination compresses CEO pay in equilibrium, though this effect is weakened by entrenchment. Counterfactual experiments reveal an 10.3% reduction in average CEO compensation upon the elimination of entrenchment. Moreover, entrenchment is more costly for shareholders than moral hazard; on average, firm value increases by 6.3% when eliminating entrenchment compared to 1.3% when eliminating moral hazard. Entrenchment slows the rate at which low-quality CEOs are terminated and increases the cost of aligning incentives, exacerbating the severity of moral hazard.