It is well established that in modern firms, where ownership and management are separated (Fama and Jensen, 1983), one of the key aspects of corporate governance codes relates to man- agerial compensation decision-making (van Witteloostuijn et al., 2007). Within this framework, existing evidence suggests that owners design their managers’ compensation contracts so as to motivate them to gain a competitive advantage in the market (Murphy, 1999; Jensen et al., 2004).
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 owner has the opportunity to compensate his manager with an incentive contract, combining own profits and sales or revenues, in order to direct him to a more aggressive behavior in the market, so as to force the rival firm to reduce output.1 Empirical studies by Jensen and Murphy (1990) and Lambert et al. (1991) report that managerial compensation is often associated with firms’ profits and size, as measured by sales or revenues. In a similar vein, Gibbons and Murphy (1990), along with Joh (1999) and Aggarwal and Samwick (1999) report that a widely used practice among firms’ owners, when designing their managers’ compensation contracts, is to take into account the relative performance of own profits against their rivals’ profits. Miller and Pazgal (2001; 2002; 2005) formalize these arguments with the “relative performance” contracts, where a manager’s compensation is a linear combination of own profits and the relative performance against the rivals’ profits. In this case too, firms end up in a prisoners’ dilemma situation. However, firms’ profits are higher than the respective under contracts combining own profits and sales or revenues. From another perspective, Peck (1988) and Borkowski (1999) mention that market share is highly ranked in managers’ objectives and Jansen et al. (2007) and Ritz (2008) offer formal analyses of contracts combining own profits and own market share.
1In 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 either own sales or own revenues. In the second stage, managers, knowing compensation schemes, compete in quantities. Each 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 with relatively higher output and lower profits.
Our paper contributes to the relevant literature by investigating the impact of product sub- stitutability on the types of contracts that firms’ owners choose to compensate their managers, as well as on the resulting output levels, profits and social welfare. In particular, the present paper attempts to address the following four questions. First, what is the effect of product substitutability, and the respective competitiveness in the final good market, on the output lev- els set by managers and the resulting firms’ profits? Second, how does the degree of product substitutability affect the firms’ owners decisions, regarding the types of contracts that they will choose to compensate their managers? Our third question has been motivated by a careful review of the existing literature in the field of strategic managerial incentive contracts. This literature has been grounded on the assumption that firms’ owners commit over the types of contracts that they choose to compensate their managers. Then, the question that easily arises is whether the results obtained with ex-ante commitment still hold without commitment. The final question that the present paper addresses is relevant to the societal effects of the different managerial incentive contracts.
To address the above questions, we build upon Jansen et al. (2009) framework, with one important departure. We assume that the two competing firms produce differentiated instead of homogeneous products. In this environment, we consider a three-staged game with observable actions: In stage one, each firm’s owner commits to one type of contract to compensate his manager. More specifically, each owner commits to a contract that is a linear combination of own profits and either own revenues (Profits-Revenues contract), or competitor’s profits (Relative Performance contract) or, finally, own market share (Market Share contract). In the second stage of the game, given that the types of contracts have become common knowledge and can not be reset, each owner sets the weight (managerial incentive parameter) between own profits and either own revenues, or competitor’s profits, or own market share. At the final stage, managers compete in quantities.