Endogenous Strategic Managerial Incentive Contracts

Endogenous Strategic Managerial Incentive Contracts

This paper studies the endogenous structure of incentive contracts that firms' owners offer to their managers, when these contracts are linear combinations either of own profits and own revenues, or of own profits and competitor's profits or, finally, of own profits and own market share.

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Orthodox economic theory treats firms as economic agents whose main objective is to maximize profits. However, already in the 1950s, Baumol (1958) suggested a sales-maximization model of firms’ objective function as a realistic alternative to the profit-maximization one. More recently, Fershtman and Judd (1987) argue that a proper analysis of the firm’s objective function should be undertaken under the prism of the separation of ownership and management. They further argue that such an analysis should incorporate the structure of the incentives that owners offer to managers in order to motivate them.

The purpose of this paper is precisely to study the endogenous emergence of the structure of contracts that firms’ owners offer to their managers so as to motivate them, and how this in turn influences market performance and societal outcomes.

The strategic use of managerial incentive contracts has been introduced in the literature by the path-breaking papers of Vickers (1985), Fershtman (1985), Fershtman and Judd (1987) and Sklivas (1987). In this line of research, each firm’s owner offers 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. In particular, in the above series of papers, in two-staged oligopoly models, in the first stage of the game, profit-maximizing owners choose compensation schemes for their managers that are linear combinations of own profits and own revenues. In the second stage, managers, knowing compensation schemes, compete in quantities. Each firm’s owner, when determining his manager’s incentives, has an opportunity to become a Stackelberg leader, provided that the rival owners do not delegate output decisions to managers. In equilibrium, all owners act in the same way at the game’s contract stage and firms end up in a prisoners’ dilemma situation.

Regarding the structure of managerial incentive contracts, recent empirical evidence has highlighted new perspectives. Gibbons and Murphy (1990), along with Joh (1999) and Aggarwal and Samwick (1999) support that in most cases, firms’ owners, when constructing the incentive contracts for their managers, take into account competitors’ profits along with their own profits. Miller and Pazgal (2001; 2002; 2005) formalize this argument in what they call “Relative Performance” contracts. In a two-staged game, firstly, owners offer to their managers contracts that are linear combinations of own profits and competitors’ profits. In the second stage, managers compete in an oligopolistic industry. Equilibrium analysis suggests that when firms’ owners manipulate their managers’ incentives, they direct the quantity-setting (price-setting) managers to a more (less) aggressive behavior, compared to the strict own-profit maximizing behavior that owners would exercise.

From another perspective, Peck (1988) mentions that market share is highly ranked in managers’ objectives. In a survey for corporate objectives among 1000 American and 1031 Japanese top managers, Peck (1988) documents that increasing market share is ranked third in the American and second in the Japanese sample. Jansen et al. (2007) and Ritz (2005) formalize the case of “Market Share” contracts. In a duopolistic market, in the first stage of a two-staged game, each owner offers to his manager a contract that is a linear combination of own profits and own market share. In the second stage, managers compete either in quantities or in prices. Their main result is that for the case of Cournot (Bertrand) competition, quantities (prices) set from managers compensated with Market Share contracts are higher than those set by strict profit-maximizing owners. 

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