In Discussion Paper No. 1382, Research Fellow Klaus Schmidt shows that increased competition has two effects on a firm’s managers: it increases the probability of the firm’s liquidation, which has a positive effect on managerial effort; and it reduces the firm's profits, which may make it less attractive for managers who work hard for the firm, since there are fewer profits to share. Schmidt derives optimal incentive schemes for managers as a function of the competitiveness of the environment in which their firm operates, and offers conditions that guarantee that competition unambiguously increases managerial effort. However, these conditions need not hold for all markets. Starting from a monopoly, managerial effort may increase as additional competitors enter the market, but will eventually decrease when competition becomes too intense.

In an extension of the basic model, Schmidt shows that increased competition also weakens general resistance to change and reduces the ‘bribe’ that may have to be paid to the work-force to make it accept reorganization. Increasing the value of a cost reduction will lead to a greater effort by the manager. Furthermore, effects of the business cycle on incentives are analysed: in a recession, liquidation becomes more likely and general unemployment rises, which reduces prospects of alternative employment. As a result, the utility loss of liquidation increases, providing stronger incentives for the manager's effort and against resistance to change. This effect may explain why most big restructuring programmes are initiated during recessions.

Managerial Incentives and Product Market Competition
Klaus M Schmidt