WP 2010-15 Monopolistic Competition, Managerial Compensation, and the Distribution of Firms in General Equilibrium
ABSTRACT. We develop a general equilibrium model to show how the distribution of firm qualities, moral hazard, and monopolistic competition in the product market interact to effect the distributions of firm size and managerial compensation. We exploit the properties of the unique, stationary general equilibrium of the model to derive a number of novel implications for the relations between the firm size and managerial compensation distributions, and the effects of firm and product market characteristics on these distributions. Our results highlight a novel general equilibrium channel through which firm and product market characteristics affect managerial compensation and incentives. Different determinants of competition have contrasting effects on the distributions of firms and managerial compensation. An increase in the entry cost or exit probability decreases expected managerial compensation and the average size of firms, but increases the number of active firms. An increase in the elasticity of product substitution, however, decreases expected compensation if firm size is below an endogenous threshold, but increases expected compensation if firm size is above the threshold. An increase in productivity risk raises expected managerial compensation and the number of active firms. In general equilibrium, aggregate shocks to the manager firm match quality distribution and firms productivity levels affect compensation and incentives. Expected managerial compensation and average firm size decrease with the productivity level, while the number of active firms increases. We use our theoretical results to develop ten robust empirically testable hypotheses that relate industry characteristics – the entry cost, the exit probability, the elasticity of product substitution, the productivity risk, and the productivity level – to managerial compensation and the number of firms in the industry. We show support for nine of the ten hypotheses in our empirical analysis.