Large Breach Penalties and Managers´ Incentives to Invest Inside or Outside Firms

Managers´ incentives to invest in firms´ specific activities (internal investments) are compared with those to realize activities to increase their alternative market opportunities (external investments) when a managerial contract establishes a large breach penalty in the event of employment termination and wage bargaining occurs according to the outside-option principle. First, it is shown that internal and external investments are incentive substitutes from the manager´s viewpoint. Furthermore, large breach penalties against firms reduce managers´ incentives to invest inside (and raise those to invest outside) the incumbent employment relationship. By contrast, large breach penalties against managers perform better in enhancing managers´ firm-specific investments.