Executive Compensation, Strategic Competition, and Relative Performance Evaluation: Theory and Evidence
Rajesh K. Aggarwal
Andrew A. Samwick
Dartmouth College - Department of Economics; National Bureau of Economic Research (NBER)
This paper examines optimal compensation contracts for managers of firms in imperfectly competitive markets. Previous studies have not found convincing evidence of high-powered incentives and relative performance evlauation. We show that strategic interactions among firms can explain this lack of strong performance-based incentives. When managers can be compensated based on their own and their rivals' performance, the need to soften product market competition generates an optimal compensation contract that places a positive weight on both own and rival performance. Across industries, the theory also predicts that firms in more competitive industries place greater weight on rival firm performance relative to own firm performance. We test the predictions empirically using recent data on compensation of executives at large corporations. We find evidence of a positive sensitivity of compensation to rival firm performance which is increasing in the degree of competition in the firm's industry.
JEL Classification: J33
Date posted: December 11, 1996