A recent empirical literature shows that competition among ?rms tends to increase the performance-pay sensitivity of compensation schemes (Burges and Metcalfe 2000, Cu?at and Guadalupe 2004, 2008 and 2009, Guadalupe 2007 and Karuna 2004). In this paper, I offer an explanation for this empirical regularity.
Earlier theoretical literature has suggested an ambiguous relationship between competition and the incentive schemes in ?rms. Holmstrom (1982) and Nalebu? and Stiglitz (1983) argue that more intense competition generates more information, which can be used to mitigate moral hazard problems. This makes incentive pay more attractive. Hart (1983) instead takes the stand that managerial slack is reduced by the competitive market pressure, which reduces the need for incentive pay.’
Schmidt (1997) argues that, on the one hand, higher level of competition will increase the marginal pro?t to cost-cutting activities and therefore the contract will provide steeper incentives to induce the manger to exert more effort. On the other hand, because it reduces average pro?ts, competition increases the likelihood of bankruptcy. The threat of bankruptcy implicitly disciplines the employees, which implies that ?at incentives are attractive. Raith (2003) allows for entry and exit in a similar model, which implies that competition does not affect the average pro?ts in the industry and therefore that it unambiguously generates more incentive-based wage schedules.
I model a ?rm’s choice between an incentive-based or a ?xed wage schedule as a trade off between the stimulating effect an incentive-based wage schedule has on productive investments compared to the costs of intra-?rm rent-seeking investments it gives rise to. This type of investment may arise when wage contracts are incomplete (see e.g. Hart and Moore 1990) or when effort is dif?cult to observe (see e.g. Alchian and Demsetz 1972). To obtain a higher wage, an increase in the probability of getting promoted or a better oi?ce, etc., workers may spend time with peers and managers, supplying information and opinions. These activities are a matter of intra-?rm reallocation, i.e., they increase the worker’s own wage but not the value of the ?rm, and resources are therefore wasted. By committing to a ?xed rule of equal sharing, the breeding ground for such intra-?rm rent seeking can be eliminated at the cost of workers having less incentive to work hard.
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Firm Competition and Incentive Pay: Rent Seeking at Work
