Relative Performance Evaluation, Sabotage and Collusion

Abstract

Relative performance evaluation (“RPE”) is a useful tool for shielding risk averse agents from systematic uncertainty. However, RPE can also destroy firm value by encouraging executives to implement excessively aggressive product market strategies to improve their relative standing through costly sabotage. We posit that explicit collusion restricts a firm’s ability to engage in sabotage, thereby improving the net benefits of RPE. Consistent with this hypothesis, we document that: (1) cartel members are more likely to use RPE, especially in more concentrated markets; (2) conditional on using RPE, cartel members include more economically similar firms in their peer group; (3) firms are disproportionately likely to drop RPE from their executives’ pay package within one year of their cartel being dissolved by a plausibly exogenous intervention; and (4) RPE is associated with greater product market aggression, but only among non-cartel firms. Collectively, our evidence suggests that the potential for costly sabotage is an important deterrent to firms’ reliance on RPE, and that explicit collusion mitigates this effect, thereby facilitating more efficient risk-sharing.