Market Competition and Managerial Incentives with Heterogeneous Firms

We incorporate managerial e¤orts inside …rms in a standard monopolistic competition model a la Krugman(1980) with heterogenous …rms. The manager works to increase probability of productivity improvement for the …rm. Due to unobservable managerial e¤ort and limited liability, the optimal managerial compensation scheme links the market performance of the …rm to managerial incentives. Managers in …rms with higher initial productivity work harder and receive higher compensation. Shocks to market structure (e.g. increases in market competition or increases in …xed cost), tend to induce higher managerial e¤ort in all surviving …rms particularly in favour of the top ones. In equilibrium, the managerial e¤ort e¤ect ampli…es the selection e¤ect in the Melitz model (2003) and induce more drastic reallocation of resources from low productivity …rms to high productivity …rms. The model also generates interesting empirical implications about distribution of managerial payment (e.g. CEO compensation) across industries and across …rms within an industry upon shocks to Economics Department and Cenre for Economic Performance, the London School of Economics, Houghton Street, London WC2A 2AE, UK. Email: [email protected]; Tel:+44 (0)20-79557080; Fax: +44 (0)20-79557595. The author is very grateful to Dalia Marin, Stephen Redding, Daniel Sturm and John Van Reenen for their encouragement and advice.