Executive Compensation, Strategic Competition, and Relative Performance Evaluation: Theory and Evidence

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Abstract
We examine compensation contracts for managers in imperfectly competitive product markets. We show that strategic interactions among firms can explain the lack of relative performance‐based incentives in which compensation decreases with rival firm performance. The need to soften product market competition generates an optimal compensation contract that places a positive weight on both own and rival performance. Firms in more competitive industries place greater weight on rival firm performance relative to own firm performance. We find empirical evidence of a positive sensitivity of compensation to rival firm performance that is increasing in the degree of competition in the industry.

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