05/06/2008
Strategic Delegation in Experimental Duopolies with Endogenous Incentive Contracts

Strategic Delegation in Experimental Duopolies with Endogenous Incentive Contracts

We study the endogenous emergence of incentive contracts used by firm owners to delegate the strategic decisions of the firm

Topics: Game Theory , Theory
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Neoclassical economics consider firms as economic agents whose main objec- tive is to maximize profits. However seminal papers such as Baumol’s (1958) suggested a sales-maximization model of firms’ objective function as a realis- tic alternative to the profit-maximization one. More recently, Fershtman and Judd (1987) argued that a proper analysis of the firm’s objective function should be undertaken under the prism of separation between ownership and management. They further argued that such an analysis should incorpo- rate the structure of the incentives that owners offer to managers in order to motivate them.

The strategic use of managerial incentive contracts has been introduced in the Industrial Organization literature by Vickers (1985), Fershtman (1985), Fershtman and Judd (1987) and Sklivas (1987). In this line of research, each owner has the opportunity to delegate market competition decision and offer an incentive contract to his manager in order to direct him to a more aggressive behavior in the market, so as to force the competing manager to reduce output. When determining his manager’s incentives each owner has an opportunity to obtain competitive advantage via delegation, provided that rival owners do not delegate any decisions to managers. Typically, in equilibrium, all owners act in the same way, engaging in a prisoners’ dilemma.

In this context, the choice of contract terms determines whether the man- ager’s reward will depend more on the firm’s profits or some other alternative objective like for example the firm’s sales. Incentive schemes which are com- binations of profit and revenue have been extensively studied. On the con- trary, other types of incentive contracts which reward the manager according to different objectives like relative performance in the market have received much less attention. Miller and Pazgal (2001, 2002, 2005) formalize the idea that each manager may be concerned with the competing firms’ performance when making his decision, under the ‘Relative Performance’ type of dele- 

gation schemes. The equilibrium outcome of the aforementioned model is similar to the one obtained under the one that includes a linear combination of profits and sales delegation schemes.

In this paper, we present and experimentally test an oligopoly delegation model in which firms’ owners choose between incentive contracts which re- ward managers according to combinations of profit and revenue or profit and relative performance. In fact, in the presence of these two alternative incen- tive schemes, firms’ owners decisions concern both the objectives that should be pursued by their managers as well as on the mixture of these objectives in the manager’s final reward. Our theoretical results predict that owners will induce their managers the objective of maximizing their firm’s performance relative to other firms.

To our knowledge, Huck et al. (2004) is the only previous experimen- tal study on delegation of objectives in oligopoly. However, in their frame- work, the choice of firm owners is limited to the terms of an exogenously imposed profit-revenue incentive scheme. Therefore, ours is the first exper- iment allowing subjects to choose between two different incentive contract types independently and before the actual terms of the contract are chosen. Furthermore, contrary to the discrete strategy space used by these authors to implement a reduced form of the underlying game, we have used a finer grid for both output choices and contract term parameters.

Compared with Huck et al. (2004), our findings are far more supportive for the main theoretical prediction concerning the use of objectives other than mere profit maximization. Generally speaking, some of our model’s predictions receive strong support by our experiments, while others receive much weaker support or are even rejected. First, the prevalence of the Relative Performance contract type over the Profit Revenue alternative is strongly confirmed. However, we are able to disentangle the two motives offered by the theoretical study for such prevalence. The explanation based on the selection of focal, Pareto superior points receives clear support against the alternative of strategic commitment on contract types before the terms of the incentives are fixed. Second, the predicted higher aggressiveness under Relative Performance incentives is observed only in asymmetric configurations involving co-existence of both types of contracts. Third, contrary to the theoretical predictions, output is not responsive either to contract type, or to contract terms.

The above experimental results indicate that the theoretical literature on strategic delegation in oligopoly may have ignored some important issues that matter in this context. The most prominent among the issues ignored in the aforementioned theoretical models seems to be fairness. Given that owners and managers are assumed to be absolute own utility maximizers, the latter are expected to accept any reward above their reservation salary no matter how unfair the split of the firm’s profits may be. However, since the seminal ultimatum experiment by Güth et al. (1982), we know that an agent receiving an unequal proposal of sharing a given profit with another agent may prefer earning nothing than earning an unfairly low amount of money. Later, an influential strand of literature emerged on economic behavior which is driven by other motives than pure short-run own utility maximization. Furthermore, in a principal-agent relationship, agents may have preferences on the competitiveness of the incentive scheme according to which they will be compensated. For example, it would be plausible to suspect that hyper- competitive incentive schemes may be negatively perceived by agents. This phenomenon has never been studied so far in the context of strategic dele- gation in oligopoly. This task is partially undertaken here, and this makes our study interesting for researchers working on the design of incentives and delegation of different levels of decision making within collective decision making entities like firms which then compete with other entities of a similar structure. 

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