Traditional literature of international trade typically treats firm as a production function: a firm is nothing but a collection of technology converting inputs into outputs. Market structure exerts direct impact on the firms productivity, always represented by marginal cost. This is not satisfactory when one is aware of two strands of media reports and economic research. One is that internal structure of firms (e.g. CEO compensation, organizational mode) varies across industries and across countries.
The other is more obvious: the internal structure has significant effect on a firms market performance. This paper is about to embed a more structured firm into a standard monopolistic competition framework, which has been widely used in international trade.
In particular, we are going to introduce a manager to run the firm in the economy. By hiring a manager, the firm obtains chance to improve productivity but also suffers moral hazard problem because the managerial effort is unobserved. We concentrate on a typical moral hazard problem when the agent is subject to limited liability or wealth constraint. The limited liability endogenizes two types of managerial effort. When the managers participation constraint is binding, the managerial effort is fixed. When the participation constraint is relaxed, the managerial effort is dependent of the firms market performance.
In the latter case, there are interactions between the managerial effort and market structure. Two particular defining features of market structure, fixed cost in an industry(country) and substitutability between goods, have significant effects on managerial effort. We will show that in the long run, either an increase in fixed cost or an increase in elasticity of substitution tends to induce larger managerial effort and enhance the productivity of each individual firm and thus the aggregate productivity. In other words, our model predicts that managers in industries, in which the fixed cost is larger or the elasticity of substitution is higher, work harder and get better paid.
It has been realized that firms within one industry have substantial variation in productivity and size. The fixed cost may act as a screening device to select firms into the market: only firms with high enough productivity can cover this irreversible fixed cost and survive in the market. We incorporate this idea by using a heterogeneous firm framework. We show that when the managerial effort is related to the firms market performance, the managerial effort effect can to amplify the selection effect. Moreover, the heterogeneity in managerial efforts across firms tends to induce more drastic redistribution of resources from less productive firms to more productive firms particularly in favour of the top ones.
The purpose of our paper is to set up a model to incorporate managerial incentive into a standard market structure of monopolistic competition. This allows us to investigate the shocks of market structure on firm productivity through internal structure of firm, which we believe is an important mechanism in real economy. Our theory generates a number of empirically testable results about market structure and the distribution of productivity. The model also suggests methods of distinguishing the managerial effect and the selection effect. Moreover, the model has interesting empirical implications about distribution of managerial payment (e.g. CEO compensation) across industries and across firms within an industry upon shocks on market structure.
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