Managerial Ability and Labor Investment

The capability of higher-ability managers to acquire and use resources more efficiently than lower-ability managers suggests a positive linear relation between labor investment efficiency (LIE) and managerial ability (MA). However, a puzzle emerges about how the best managers set themselves apart from their peers, calling into question the linearity of the relation between LIE and MA. We explore this puzzle by asking how the highest-ability managers achieve the highest performance levels. We then investigate this puzzle empirically by considering alternatives to a linear relation between LIE and MA. We begin with the distinction that managers achieve the highest performance when they combine efficient exploitation of existing products and services with successful exploration for innovations in products and services. This point is relevant to our puzzle because a firm’s labor needs for exploration are high and unpredictable. Thus, we expect the highest-ability managers to purposefully invest more than predicted by a model of optimal labor investment across firms. In contrast, we expect low-ability managers, who are less able to evaluate, forecast, and make efficient investments, to deviate more from predicted labor investment and vacillate between over- and underinvestment. We present evidence that supports our predictions of nonlinear relations between LIE and MA, with high-ability managers investing more than predicted and low-ability managers over- and underinvesting. We make and test related hypotheses about exploration (investment in research and development), and we probe further by relating future firm performance to over- and underinvestment in labor for different levels of MA.