The Market Mechanism as an Incentive Scheme

Abstract

It is often argued that competition in the product market reduces managerial slack. We formalize this idea. Suppose that there is a common component to firms' costs, i.e., as one firm's (total and marginal) costs fall, so do those of other firms. Then when costs fall, profit-maximizing firms expand. This reduces product prices and gives the manager of a nonprofit-maximizing firm less opportunity for discretionary behavior than if his firm's costs had fallen alone and produce prices had not changed. Hence average managerial slack is lower under competition than if there is a single nonprofit-maximizing monopolistic firm.