Career Concerns and Product Market Competition

• Published date: 01 April 2016
• Date: 01 April 2016
• Author: Fabio Feriozzi
• DOI: http://doi.org/10.1111/jems.12133

Career Concerns and Product Market Competition

FABIO FERIOZZI

Department of Finance

IE Business School - IE University

Madrid, Spain

fabio.feriozzi@ie.edu

This paper studies the effect of increased competition in the product market on managerial

incentives. I propose a simple model of career concerns where firms are willing to pay for

managerial talent to reduce production costs, but also to subtract talented executives from

competitors. This second effect is privately valuable to firms, but is socially wasteful. As a result,

equilibrium pay for talent can be inefficiently high and career concerns too strong. Explicit

incentive contracts do not solve the problem, but equilibrium pay is reduced if managerial skills

have firm-specific components, or if firms are heterogeneous. In this second case, managers are

efficiently assigned to firms, but equilibrium pay reflects the profitability of talent outside the

efficient allocation. The effect of increased competition is ambiguous in general, and depends

on the profit sensitivity to cost reductions. This ambiguity is illustrated in two examples of

commonly used models of imperfect competition.

1. Introduction

Product market competition is usually regarded as an important source of managerial

discipline in firms affected by agency problems. The basic idea, tracing back at least to

the writings of Adam Smith, is that in a competitive environment, inefficient firms are

exposed to the risk of bankruptcy and if managers want to keep their job, they must

be concerned with their firm’s efficiency and profitability. According to this argument,

increased competition should therefore provide stronger managerial incentives. The

behavior of managers, however, is affected by a variety of factors such as their com-

pensation package, board monitoring, the market for corporate control, and essentially

any kind of corporate governance mechanism.1Product market competition is likely to

have an impact on many of these factors, and is therefore likely to have additional and

nontrivial incentive effects. This paper takes a step toward a better understanding of the

disciplining role of competition by looking at its effects on managerial career concerns,

in a setup where firms also use explicit incentive contracts.

It is well known that career concerns can greatly alleviate the conflict of interest

between shareholders and managers. In an early contribution, Fama (1980) discussed

the conditions under which managerial career concerns can solve the agency problem

produced by the separation of ownership and control. The large literature emerged

A previous version of this paper circulated under the title “Career Concerns and Competitive Pressure.”I am

indebted to Marco Celentani for many insightfull discussions on earlier drafts, and two anonymous referees

for their useful suggestions. I thank Antonio Cabrales, Fabio Castiglionesi, Luis Corch´

on, Marco Della Seta,

Francesco De Sinopoli, Pietro Reichlin, Pablo Ruiz-Verd´

u, and several seminar audiences for their comments.

The financial support of the Spanish Ministry of Science and Innovation under grant no. ECO2011-30323-C03-

03 is gratefully acknowledged. The usual disclaimers apply.

1. See Shleifer and Vishny (1997) and Becht et al. (2003) for general surveys of the corporate governance

literature.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume25, Number 2, Summer 2016, 370–399

Career Concerns 371

thereafter has confirmed that career concerns indeed represent an important source of

incentives for managers (e.g., Murphy, 1999; Becht et al., 2003), even if they do not

necessarily result in first-best outcomes (e.g., Holmstrom, 1999).2

Tostudy the effects of product market competition on career concerns, I introduce a

stylized moral-hazard model that capturesthe interactions between incentive provisions,

the product market, and the managerial labor market.3In a nutshell, firms’ willingness to

pay for providing incentives, and for attracting and retaining managerial talent depends

on the profit sensitivity to firm efficiency, which, in turn, is a function of product-market

characteristics. Consistently with the existing literature (e.g., Hermalin, 1992; Schmidt,

1997; Vives, 2008), I find that contractual incentives are driven by the value of a cost

reduction, that is, by the incremental profits that a firm is able to achieve by cutting

costs. This is also true for career concerns, which, however, also depend on firms’

willingness to pay for subtracting talent from competitors. This is privately valuable

to firms, because it increases the chances of facing weak competition, but is socially

wasteful and can result in inefficiently high pay for talented managers.

I propose a two-period model where two firms sell their products on a common

and imperfectly competitive product market. Tomaintain the analysis at a general level,

product-market interactions are representedby means of a reduced-form profit function,

where a firm’s profitability depends on its own production costs as well as on those of

the competitor. Production costs are, in turn, determined by the talent and effort of the

chief executive officer (CEO). At the beginning of the first period, each firm is randomly

matched with a manager who is offered a short-term incentive contract to become the

CEO. Managerial talent is scarce, in that one of the CEOs is talented but the other is

not. Nobody knows who is the talented manager when they are first hired, but the

observation of first-period production costs can reveal talent.4If this happens, firms

bid to hire the talented manager before the second-period interaction on the product

market. Tosimplify the analysis, there is no moral-hazard problem in the second period,

when firms’ ability to cut costs only depends on their current CEO’s talent. Finally,

managerial skills have firm-specific components that are lost if a manager switches

to the competitor. This limits the second-period equilibrium pay for talent and curbs

managerial reputational concerns.

Two are the main determinants of managerial incentives. First, the value of a cost

reduction, which is measured by the incremental profits obtained by a firm that reduces

its production costs. Second, a cost-reduction externality, which is instead measured by

the profit drop that a firm that cuts its costs imposes on its competitor. A cost-reduction

externality is not unusual among firms operating on a common and imperfectly com-

petitive product market. It can result, for example, from a business stealing effect, by

which less efficient firms tend to lose customers that prefer to switch to more efficient

competitors, offering smaller prices or better products. In this setup, the first-best level

of effort is increasing in the value of a cost reduction but decreases with its external

effect. However, career concerns are shown to increase in the cost-reduction externality,

2. A strand of the literature has also considered situations where career concerns have perverse incentive

effects. See, for example, Holmstrom and Ricart (1986), Prendergast (1993), Zwiebel (1995), and Prat (2005).

3. In recent years, the market for top executives has widened substantially also as a result of a shift from

firm-specific skills toward more general managerial skills (Murphy and Z´

abojn´

ık, 2004; Frydman, 2013). See

also Gabaix and Landier (2008), and Tervi¨

o (2008; 2009) for recent studies of the market for CEOs.

4. The assumption that there is exactly one talented manager in the economy simplifies the derivation of

many results, and is primarily made for the sake of presentation. Section 7, however,discusses the robustness

of the results by considering the alternative assumption of independent managerial types.