Product Market Competition, Managerial Compensation and Firm Size in Market Equilibrium

Ajay Subramanian, Georgia State University addresses Product Market Competition, Managerial Compensation and Firm Size in Market Equilibrium

ABSTRACT: We develop a tractable equilibrium model of competing firms in an industry to show how the distribution of firm qualities, moral hazard, and product market characteristics interact to affect firm size, managerial compensation, and market structure. Equilibrium effects cause different determinants of product market competition — the entry cost and the elasticity of substitution — to have sharply contrasting effects on firm size and managerial compensation. While both firm size and managerial compensation increase with the entry cost, they increase with the elasticity of substitution if and only if firm size exceeds a high threshold, but decrease if it is below a low threshold. We also show how the distribution of firms’ productivity shocks affects firm size, managerial compensation, and market structure. Aggregate shocks to the firm productivity distribution affect incentives in our equilibrium framework. We develop and test a number of qualitative hypotheses that relate product market/industry characteristics to CEO compensation, firm size, and the number of firms in the industry. We show statistically and economically significant empirical support for all the hypotheses. In particular, different determinants of product market competition indeed have sharply contrasting effects on managerial compensation, firm size, and the number of firms as predicted by the theory.