Product market competition and organizational slack under profit-target contracts

In a framework a la Martin (1993) we introduce a common component in the managers' private information in order to address three related questions: What is the impact of contracts that reward managers on the basis of realized profits on firms' productive and allocative efficiency relative to cost-target contracts? How do these contracts shape the relationship between competition and organizational slack? Can we then explain the existing evidence of an inverted-U shaped relationship between competition and cost-reducing activities, as documented in Aghion et al. [Aghion, P., Bloom, N., Blundell, R., Griffith, R., Howitt, P., "Competition and innovation: an inverted-U Relationship", The Quarterly Journal of Economics, 120: pp. 701-728, 2005]? We show that profit-target contracts introduce a horizontal (contractual) externality between the competing firms that mitigates organizational slack and improves upon productive efficiency relative to cost-plus mechanisms. Moreover, when executive compensations are conditioned on profits, an inverted-U shaped relationship between product market competition and managerial effort obtains. Finally, we also show that when contractual instruments are endogenous, i.e., when shareholders can choose between profit- and cost-target rules, the equilibrium with profit-target contracts always exists and is the only one that survives to standard refinements.

[1]  J. Laffont,et al.  Competition and the reform of incentive schemes in the regulated sector , 2003 .

[2]  Humberto Moreira,et al.  Common agency with informed principals , 2004 .

[3]  M. Katz.  Game-Playing Agents: Unobservable Contracts as Precommitments , 1991 .

[4]  M. Armstrong,et al.  Recent developments in the theory of regulation , 2007 .

[5]  Philippe Aghion,et al.  Competition and Innovation: an Inverted-U Relationship , 2005 .

[6]  J. Laffont,et al.  A Theory of Incentives in Procurement and Regulation , 1993 .

[7]  J. Lawarree,et al.  Input Versus Output Monitoring: Who Is the Residual Claimant? , 1995 .

[8]  Stephen Martin,et al.  Endogenous Firm Efficiency in a Cournot Principal-Agent Model , 1993 .

[9]  Stephen Nickell,et al.  Competition and Crporate Performance , 1993 .

[10]  Benjamin E. Hermalin,et al.  The Effects of Competition on Executive Behavior , 1992 .

[11]  D. Scharfstein.  Product-Market Competition and Managerial Slack , 1988 .

[12]  David Martimort,et al.  Selecting equilibria in common agency games , 2009, J. Econ. Theory.

[13]  Johan Stennek.  Competition increases x-efficiency: A limited liability mechanism , 2000 .

[14]  E. Gal‐Or,et al.  Vertical integration or separation of the sales function as implied by competitive forces , 1999 .

[15]  Michael Raith,et al.  Competition, Risk and Managerial Incentives , 2001 .

[16]  I. Vogelsang,et al.  Handbook of telecommunications economics, volume I. structure, regulation & competition. Cave, M., Majumdar , 2010 .

[17]  E. Maskin,et al.  Input Versus Output Incentive Schemes , 1985 .

[18]  David Martimort,et al.  The Strategic Value of Quantity Forcing Contracts , 2010 .

[19]  David Martimort,et al.  Exclusive Dealing, Common Agency, and Multiprincipals Incentive Theory , 1996 .

[20]  J. Laffont,et al.  Mechanism Design with Collusion and Correlation , 2000 .

[21]  S. Nickell.  Competition and Corporate Performance , 1996, Journal of Political Economy.

[22]  David A. Malueg,et al.  Preemptive Investment, Toehold Entry, and the Mimicking Principle , 1991 .

[23]  Barry Nalebuff,et al.  Information, Competition, and Markets , 1983 .

[24]  Paolo Bertoletti,et al.  X-Inefficiency, Competition and Market Information , 1997 .

[25]  Thomas P. Tangerås.  Collusion-proof yardstick competition , 1999 .

[26]  D. Martimort,et al.  Resale price maintenance under asymmetric information , 2007 .

[27]  J. Laffont,et al.  The Theory of Incentives: The Principal-Agent Model , 2001 .

[28]  Oliver Hart,et al.  The Market Mechanism as an Incentive Scheme , 1983 .

[29]  R. Myerson.  Optimal coordination mechanisms in generalized principal–agent problems , 1982 .

[30]  J. Laffont,et al.  Using Cost Observation to Regulate Firms , 1986, Journal of Political Economy.

[31]  Klaus M. Schmidt.  Managerial Incentives and Product Market Competition , 1997 .