Managerial Preferences and Competition in Internal Capital Markets

It is often argued that managers follow some preference function. The internal capital market literature, for example, most commonly treats managers as empire builders who receive increased private bene…ts from having more funds under their control. However, recent empirical work (Bertrand and Mullainathan 2003), shows that some managers might prefer to be left to run a limited number of projects. This "enjoying the quiet life" constitutes an alternative type of managerial behavior. In this contribution, we demonstrate how empire building and quiet life preferences work under competition. Our analysis shows that quiet life managers can generally only be motivated by threatening them with competition, while empire builders also value enhanced investment prospects. As we also demonstrate, this leads to di¤erent optimal wages in regard to managerial preferences. Additionally we identify two organizational ways to improve managerial incentives. Namely, by letting managers with di¤erent investment prospects compete for funds and by altering the ex ante distribution of funds among the department managers. Again, results vary significantly with di¤erent managerial preferences.