Product Market Competition and Productive Managerial Effort

This paper analyzes a mechanism through which product market competition affects allocation of the managerial efforts. There are two types of firms, incumbents and entrants. Each incumbent firm delegates its control to a manager and cannot observe the manager's effort. The managers of incumbent firms allocate their effort to two different activities: cost reduction (productive effort) and rent protection (unproductive effort). An increase in competition, measured by the number of incumbent firms, has two effects: an ``output effect" which decreases the managerial incentive for productive effort, and an ``effort substitution effect" that makes managers exert more productive effort and less unproductive effort. This paper identifies the conditions under which product market competition lowers the cost of providing incentives for productive effort and hence, to the conclusion that increased competition leads to increased efficiency