Monday, January 31, 2011

Short-Term Managerial Contracts Facilitate Cartels

Posted by D. Daniel Sokol

Martijn A. Han, University of Amsterdam - Amsterdam Center for Law & Economics (ACLE) suggests that Short-Term Managerial Contracts Facilitate Cartels.

ABSTRACT: This paper shows how a series of commonly observed short-term CEO employment contracts improves cartel stability compared to a long-term contract. When a manager’s short-term appointment is renewed if and only if the firm hits a certain profit target, then (a) defection from collusion results in superior firm performance and thus reduces the chance of being fired immediately, while (b) future punishment results in inferior firm performance, thereby increasing the chance of being fired in the future. The introduction of this reemployment tradeoff intertwines with the usual monetary tradeoff and weakly improves cartel stability. Studying the impact of fixed versus variable salary components, I find that fixed components facilitate collusion with a short-term contract, while not affecting cartel stability with a long-term contract. I extend the model to argue how short-term renewable contracts are a source of cyclical collusive pricing. Finally, interpreting the results in the light of firm financing shows how debt-financed firms can form more stable cartels than equity-financed firms.

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