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Analytical Studies Branch Research Paper Series


Product Market Competition and Agency Costs

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Product Market Competition and Agency Costs

by Jen Baggs and Jean-Etienne de Bettignies

Executive summary

Economists have long held the belief that competition improves efficiency. One of the mechanisms suggested is that product market competition alleviates agency costs, which in turn may enable firms to induce higher effort and greater efficiency from their managers. In this way, competition mitigates what Leibenstein (1966) called "X-inefficiencies." Despite growing interest, an unambiguous theoretical formulation for this "vague suspicion" has proved difficult to obtain. In this paper we examine the impact of competition on efficiency both theoretically and empirically.

The main theoretical contribution of this paper is to show that product market competition can have a direct, and ambiguously positive effect on managerial incentives. In our model, two firms are located at the extremities of a Hotelling (1929) line, and compete in quality and prices for consumers on that line. Competition is measured by the degree of substitutability between products, and agency problems arise as a result of a managerial wealth constraint. Within this framework, the following results apply:

  1. When agency costs are present — as in large or hierarchical firms for example, where the separation of ownership and control is likely to play an important role — competition unambiguously and "directly" lowers the shareholders' marginal cost of inducing effort by the manager. In equilibrium, this leads to higher powered incentives, higher managerial effort, and increased product quality (or reduced costs).
  2. When agency costs are nonexistent — as in small, entrepreneurial firms for example, where the owner and the manager are one and the same person — competition has no impact on quality-improving effort by the manager. Note that consistent with economists' belief, and in contrast to previous work, here the unambiguous effects of competition arise specifically through a reduction in agency costs, and are absent in a first-best world.

Our empirical contribution comes from our ability to analyze comprehensively both whether competition affects firm behaviour, in terms of quality improvements, costs reductions and other efficiency-related outcomes, and the process through which this might occur. We exploit the Workplace and Employee Survey (WES) data set, a detailed set of linked employer-employee data, which allows us to observe simultaneously the amount of competition firms face, the strategies they pursue, the types of contracts and incentives offered to their employees, as well as detailed information about individual employee effort. This allows us to test empirically all aspects of our theoretical model, analyzing the effect competition has on the importance firms place on quality (or cost), their use of incentive-based contracting, as well as agent effort. We find that the predictions of our model are consistent with the data. Mainly:

Our results yield an interesting policy implication: competition policy that is focused on large corporations in which agency problems play a large role, may be more beneficial to efficiency improvements.

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Date modified: 2006-12-04 Important Notices