Product Market Competition and Top Management Compensation
Posted: 9 Jun 1997
Date Written: Undated
This paper examines the effect of competition in the product markets on the design of a firm's governance structure. In oligopolies, profits are not just a function of a firm's own actions but also of the actions taken by rivals. Firms therefore behave strategically and commit to actions which elicit the most favorable responses from rivals. It is shown both theoretically and empirically that firms strategically use incentive features of compensation contracts to alter behavior in product markets. When a firm's output market decisions are strategic substitutes (i.e., marginal profits decrease with an increase in the rival's actions) managerial incentives are decreased, while if these decisions are strategic complements (i.e., marginal profits increase with an increase in the rival's actions) managerial incentives are increased. I develop an empirical measure which captures the sensitivity of a firm's marginal profits to changes in its rival's actions. An examination of CEO incentives in the data shows that when strategies are strategic substitutes, CEOs get awarded stock options with lower pay for performance incentives, own a smaller percentage of the firm and have a smaller threat of dismissal following bad performance of the firm. On the other hand, when strategies are strategic complements CEOs get higher pay for performance incentives from both cash and stock based compensation.
JEL Classification: D21, J33
Suggested Citation: Suggested Citation