Incentives and managerial effort under competitive pressure: An experiment

Abstract

We investigate how increased competition affects firm owners׳ incentives and managers׳ efforts in a laboratory experiment. Each owner offers a compensation scheme to his manager in two different conditions: under monopoly and under Cournot duopoly. Following acceptance of the compensation, the manager chooses an effort level to increase the probability of a cost-reduction which affects the firm׳s profit. According to standard theoretical predictions the entry of a rival firm in a monopolistic industry affects negatively both the incentive compensation and the effort level. Our experimental findings show that the entry of a rival firm has two effects on managerial effort: an internalization effect which affects positively the level of effort and an income effect which has a negative impact on effort. The combined outcome of these two effects is neutral with respect to managerial effort: we observe that when competition reduces the firm׳s profit, the owner reacts by offering lower incentives but despite the lower incentives the manager still accepts the contract offer and exerts the same level of effort than under the monopoly condition.