In a framework à la Martin (1993) we introduce a common component in the managers' private information in order to address three related questions: What is the impact of contracts that reward managers on the basis of realized profits on firms' productive and allocative efficiency relative to cost-target contracts? How do these contracts shape the relationship between competition and organizational slack? Can we then explain the existing evidence of an inverted-U shaped relationship between competition and cost-reducing activities, as documented in Aghion et al. [Aghion, P., Bloom, N., Blundell, R., Griffith, R., Howitt, P., “Competition and innovation: an inverted-U Relationship”, The Quarterly Journal of Economics, 120: pp. 701–728, 2005]? We show that profit-target contracts introduce a horizontal (contractual) externality between the competing firms that mitigates organizational slack and improves upon productive efficiency relative to cost-plus mechanisms. Moreover, when executive compensations are conditioned on profits, an inverted-U shaped relationship between product market competition and managerial effort obtains. Finally, we also show that when contractual instruments are endogenous, i.e., when shareholders can choose between profit- and cost-target rules, the equilibrium with profit-target contracts always exists and is the only one that survives to standard refinements.

Product market competition and organizational slack under profit target contracts

D'AMATO, Marcello;
2008

Abstract

In a framework à la Martin (1993) we introduce a common component in the managers' private information in order to address three related questions: What is the impact of contracts that reward managers on the basis of realized profits on firms' productive and allocative efficiency relative to cost-target contracts? How do these contracts shape the relationship between competition and organizational slack? Can we then explain the existing evidence of an inverted-U shaped relationship between competition and cost-reducing activities, as documented in Aghion et al. [Aghion, P., Bloom, N., Blundell, R., Griffith, R., Howitt, P., “Competition and innovation: an inverted-U Relationship”, The Quarterly Journal of Economics, 120: pp. 701–728, 2005]? We show that profit-target contracts introduce a horizontal (contractual) externality between the competing firms that mitigates organizational slack and improves upon productive efficiency relative to cost-plus mechanisms. Moreover, when executive compensations are conditioned on profits, an inverted-U shaped relationship between product market competition and managerial effort obtains. Finally, we also show that when contractual instruments are endogenous, i.e., when shareholders can choose between profit- and cost-target rules, the equilibrium with profit-target contracts always exists and is the only one that survives to standard refinements.
File in questo prodotto:
Non ci sono file associati a questo prodotto.

I documenti in IRIS sono protetti da copyright e tutti i diritti sono riservati, salvo diversa indicazione.

Utilizza questo identificativo per citare o creare un link a questo documento: http://hdl.handle.net/20.500.12570/1862
 Attenzione

Attenzione! I dati visualizzati non sono stati sottoposti a validazione da parte dell'ateneo

Citazioni
  • ???jsp.display-item.citation.pmc??? ND
social impact