Competition, Risk and Managerial Incentives
Posted: 15 Jan 2004
This paper examines how the degree of competition among firms in an industry affects the incentives that firms provide to their managers. A central assumption is that there is free entry and exit in the industry, which implies that changes in the nature of competition lead to changes in the equilibrium market structure. I show that with greater product market competition as a result of greater product substitutability or a larger market, principals unambiguously provide stronger incentives to their agents to reduce costs. At the same time, more intense competition also leads to more volatile firm-level profits. Consequently, managers' incentives are positively correlated with firm-level risk, consistent with empirical evidence. A decrease in the cost of entering the market has the opposite effect on incentives, but still induces a positive correlation between risk and incentives.
Keywords: Competition, Incentives, Risk, X-efficiency
JEL Classification: D43, L13, L22
Suggested Citation: Suggested Citation