Managerial Short-Termism and Market Competition

Abstract

This paper studies managerial short-termism by considering a model in which two firms compete for a new investment opportunity. It shows that under competition firms may deliberately induce short-termism by tying managerial pay to short-term stock prices. Due to information asymmetry between managers and financial markets regarding the investment profitability, managers under such compensation contracts tend to overinvest to signal good profitability, which gives their respective firms a competitive advantage. The intensified competition ultimately erodes firms' profits. So short-termism can arise from a prisoner's dilemma type of coordination failure among firms. Yet this collective action problem can be socially optimal.

Keywords: Short-termism; commitment; coordination failure; market competition

JEL Classification: G34, L13, M12, M52