GEP Research Paper 08/17
Openness, Managerial Incentives and Heterogeneous Firms
Zhihong Yu
Summary
This paper incorporates the managerial incentive contract mechanism into the Melitz (2003) model. Firm heterogeneity plays a crucial role in the directions of the effects of trade on managerial incentives and endogenous firm productivity.
Abstract
Motivated by new evidence that managerial incentives play an important role in determining firm productivity, this paper incorporates the principal-agent mechanism into the new heterogeneous firm trade framework to examine the link between openness and endogenous firm productivity. We show that firm heterogeneity plays a crucial role in the effects of openness on firms’ optimal incentive contracts via the trade-induced “carrot and stick” effect. This mechanism increases the marginal value of managerial effort, which motivates the firm owners (principals) to offer a higher power contract to the managers (agents) to reduce managerial slacks. The intra-firm managerial incentive mechanism stressed in this paper could be viewed as complementary to the inter-firm reallocation effect in the Melitz (2003) model in explaining the observed link between openness and aggregate productivity.
Issued in May 2008
This paper is available in PDF format