Juan Sebastián Ivars

Abstract

This paper investigates how market competition influences the way principals design incentive contracts for managers. We study a moral hazard setting where two principals each employ a risk neutral agent (manager). Each agent makes a decision on effort leading stochastically to an outcome. These outcomes are observable for each principal and used to design incentives based on their joint realizations. We isolate the effect of market competition in two channels: market information and market structure. First, market information captures the correlation between the outcomes generated by the agents. Second, market structure indicates the profits that each principal obtains from a given realization of agents’ outcomes. We make two contributions: we show i) that the optimal incentives are fully determined by the correlation of outcomes between agents; and ii) that the market structure determines whether the optimal incentive schemes are implementable. In more competitive markets, principals are limited to contracts that reward an agent’s outperformance relative to the rival. By contrast, in less competitive markets, principals can implement a wider range of optimal incentive schemes. Our analysis sheds light on why incentive design varies across industries.