Relative Performance Evaluation and Contract Externalities
33 Pages Posted: 27 Jul 2006 Last revised: 4 Mar 2008
Date Written: December 27, 2007
We consider the incentive characteristics of optimal linear contracts based on relative performance evaluation (RPE) for managers under moral hazard in imperfectly competitive product markets. Each contract influences the quantity choices of all competing agents causing contract externalities that affect the principals' contracting game. We analyze the relations between the optimal extent of RPE and several firm and market characteristics, allowing for heterogeneous firms and idiosyncratic firm risk. In general, we find non-monotonic comparative static results regarding the influence of market and firm-specific risk, the industry's competitiveness, and the correlation of the firms' profit.
Keywords: contract externalities, managerial incentives, product market competition, relative performance evaluation
JEL Classification: D43, D82, L13, M40
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