Insider trading and managerial incentives

We derive conditions under which permitting manager "insiders" to trade on personal account increases the equilibrium level of output and the welfare of shareholders. These increases are produced by two effects of insider tra ding. First, insider trading impounds information about hidden managerial a ctions into asset prices. This impounding of information allows shareholder s to make better personal portfolio-allocation decisions. Second, allowing insider trading can induct managers to increase, on average, the correlatio n between their personal wealth and firm value beyond the level dictated by the employment relationship alone. This increased correlation increases ma nagerial incentives. When these two effects are only weakly present, permit ting insider trading harms shareholders, because insider trading reduces sh areholder control over the performance-compensation relationship. In additi on, when managerial effort incentives are high and corporate governance cos ts are low. managers may prefer insider-trading restrictions because such r estrictions force shareholders to offer them a larger fraction of output th rough the employment relationship. (C) 2001 Elsevier Science B,V. All right s reserved.