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No abstract

We arguethatstrategicinteractionsbetween firms in an oligopoly can explain the puzzling lack of high-powered incentivesin executive compensationcontractswrittenby shareholderswhose objective is to maximize the value of their shares. We derive the optimal compensation contracts for managers and demonstratethatthe use of high-powered incentives will be limited by the need to soften product marketcompetition. In particular,when managerscan be compensated based on theirown and theirrivals' performance,we show thattherewill be an inverse relationshipbetween the magnitude of high-powered incentives and the degree of competition in the industry. More competitive industriesarecharacterizedby weakerpay-performanceincentives. Empirically,we find strongevidence of this inverserelationshipin the compensation of executives in the United States. Our econometric resultsare not consistent with alternativetheories of the effect of competition on executive compensation. We conclude thatstrategicconsiderations can preclude the use of highpowered incentives, in contrastto the predictions of the standardprincipal-agentmodel.