59 Pages Posted: 9 Jun 2001
Date Written: June 2001
In models by Fershtman and Judd (1987) and Sklivas (1987), firms competing in quantities benefit strategically from commiting to managerial incentives that are biased toward revenue maximization. Little empirical evidence has been produced in support of these models, and their assumption that incentive contracts are observable has been criticized as unrealistic. This paper proposes an alternative model in which firms competing in strategic substitutes commit to using less precise profit measures, which biases the optimal unobservable contract towards revenue maximization. This model performs better empirically. Firms that compete in strategic substitutes choose less precise profit measures across six different measures. Firms with less precise profit measures in turn have stock returns and thus managerial incentives that are driven more by revenue growth. Controlling for this channel, firms that compete in strategic substitutes do not directly modify their managerial incentives in the direction predicted by observable-contract models; on the contrary, having commited to more revenue-driven stock returns, they actually undo part of the resulting incentive bias using their non-stock incentives, which is consistent with unobservable contracts.
Keywords: Disclosure policy; Strategic delegation; Strategic substitutes; Strategic complements; Performance measurement; Incentives
JEL Classification: D20, L22, M40, M46, M41, M45, J33
Suggested Citation: Suggested Citation
By Kevin Murphy