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Product market competition and organizational slack under profit-target contracts

  • Piccolo, Salvatore
  • D'Amato, Marcello
  • Martina, Riccardo

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.

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Article provided by Elsevier in its journal International Journal of Industrial Organization.

Volume (Year): 26 (2008)
Issue (Month): 6 (November)
Pages: 1389-1406

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Handle: RePEc:eee:indorg:v:26:y:2008:i:6:p:1389-1406
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505551

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