Industry Tournament Incentives and Firm Innovation Output

Abstract

Using the sample of China’s listed companies over the period 2006-2015, we investigate the relationship between industry tournament incentives and firm innovation output. Specially, we measure industry tournament incentives as the gap between CEO compensation at the firm of interests and maximal CEO compensation among firms in the same industry, and find that industry tournament incentives are positively related to firm innovation output, as measured by the number of application patents. Our main findings also hold in an instrumental-variable analysis and propensity score matching analysis. To gain a clearer understanding of this result, we examine the effect of the industry promotion probability of CEOs on the relation between industry tournament incentives and firm innovation output. If industry tournament incentives are indeed positively related to firm innovation output, such a positive relation should be more pronounced when the industry promotion probability of CEOs is higher. Consistent with this argument, we find that the positive relation is more pronounced when industry homogeneity is higher and the number of CEOs in the industry is more. Next, we explore the plausible underlying economic mechanisms through which industry tournament incentives improve firm innovation output. The first plausible mechanism that we explore is the innovation input channel. We argue that industry tournament incentives can improve firm innovation output by motivating CEOs to increase innovation input. Consistent with this argument, we find that industry tournament incentives are positively related to RD Jia, et al., 2016）, but little literature examines the relation between external tournament incentives and firm innovation. Our paper contributes to this literature by showing that promotion-based industry tournament incentives are another important factor affecting firm innovation. Secondly, most of the literature focuses on the impact of capital market incentives, such as equity incentives on executive innovation behavior（e.g. Edmans, 2014; Chang, 2015; Mao and Zhang, 2018）, but little literature studies the impact of the external labor market on executive innovation behavior. We find that industry tournament incentives improve firm innovation output, which implies that the external labor market will influence executive innovation behavior. Finally, our results provide a new perspective for the public controversy over the excessive CEO compensation in China’s listed companies. The results of this paper show that the increase of CEO compensation can positively promote firm innovation output by increasing competition in the external labor market. The conclusion of this paper has important reference significance for China’s listed companies to establish an efficient innovation incentive mechanism. We find that the industry pay gap can improve firm innovation output. Therefore, companies should not only consider the internal incentive mechanism, such as equity incentives and internal tournament incentives, but also consider the incentive effect of the external labor market on executive innovation behavior.