Corporate Governance and Internal Organization

Abstract

This paper investigates how corporate governance affects managerial incentives inside the firm. While the internal organization of a firm affects competition between lower level managers to become the CEO, performance-based CEO dismissal and replacement alters the incentives due to this competition. I show that optimal governance mechanisms that dismiss CEOs are more likely to be accompanied by an outside replacement and such governance mechanisms make managerial competition more productive. However, strong governance may also reduce managerial incentives to acquire skill to become the CEO. As lower level managers have a greater impact on firm performance and increase in number, strong governance is optimal.