How does product market competition shape incentive contracts?

Abstract

This paper studies the effects of product market competition on the explicit compensation packages that firms offer to their CEOs, executives and workers. We use a large sample of both traded and non-traded UK firms and exploit a quasi-natural experiment associated to an increase in competition. The sudden appreciation of the pound in 1996 implied different changes in competition for sectors with different degrees of openness. We provide difference in differences estimates and our results show that a higher level of product market competition increases the performance pay sensitivity of compensation schemes, in particular for executives.

Three different compensation measures are used as dependent variables. These are derived from the annual company statements. The first one is total compensation of the highest paid director, and contains all of the firm’s payments to the highest paid director in a particular year, including both fixed and variable compensation elements, such as stock options.¹² Although occasionally it may be the chairman, in most cases the highest paid director is the CEO.¹³ This is the only publicly available measure of top executive pay for the UK, and the one used in virtually all related studies.¹⁴ In fact the amount of information provided on each company varies, in particular many firms do not report pay to the highest paid director explicitly.

Secondly, we use a measure of average executive pay, which contains the average remuneration received by the board members. Given that individual data is not available, this measure is calculated as the ratio of total board compensation over the number of directors. These include the top executives of the firm including the CEO, but also a proportion of non-executive directors of the firm. Ideally one would like to separate these two different types of directors, as their roles are not exactly the same. However, this is not possible in our sample. In any case, even though non-executive directors do not make direct management decisions, they do influence the strategic decisions of the firm, and can be seen as agents of the shareholders, in a way similar to executive directors. Furthermore, the presence of non executive directors in the UK is quite low when compared with the US. Previous studies estimate that the proportion of non-executive directors on the board is about 40-50% for large quoted firms. However among non quoted firms, the percentage of firms with at least one non-executive director is between 33% and 47% for large firms, and 19% for small and medium sized firms (less than 50 employees). Given the predominance of small and medium sized firms in our sample, it is likely that the proportion that do not have any non-executive director represents more than three quarters of the total number of firms.¹⁵ The pay measure is the average total remuneration of all board members, so it includes the total remuneration that executive directors receive for their executive and board activities, and the remuneration associated with being a member of the board for non-executive directors.

Finally, we use average wage in the firm constructed as total wages paid over total number of employees.¹⁶ The density of information on these three compensation variables is not constant. For the variable covering the highest paid director there is an average of 2.1 observations per firm, while for the variables on average executive pay and average wages there is a mean of 3.7 and 4.1 observations per firm respectively. We exclude from the sample firms with less than 5 employees in which CEOs and directors are hardly comparable with the rest of the sample. We also drop observations where the pay variable is zero because this appears to come from mis-coding. Table 2 contains the summary statistics of the relevant variables.

The performance measure used is earnings before interests and taxes. Most of the firms in the sample are not publicly traded. This has the advantage that it is a very broad sample of firms, representative of the whole economy. It also implies that one cannot use stock market based performance measures. Much existing literature focuses on executive compensation of publicly traded companies and uses stock market returns as their measure of performance. The fact that the vast majority of our firms are not listed on the stock market implies that the only performance measure we can use is accounting based. Existing research supports that accounting profits are a relevant measure of performance when examining compensation packages (Bushman and Smith, 2001).

To allow for any non linearities (such as minimum profits to qualify for a bonus or caps) we also include a measure of profits squared in the regressions. Size is computed by the logarithm of total assets. Year dummies, firm fixed effects and a sector-specific time trend (at 3 digit SIC) are also included in all the regressions. All the monetary variables are in constant 1987 pounds.

The measures of openness are import penetration and export share of output measured at a sector level defined by the SIC classification at three digits, as a proportion of total output plus net imports and total output respectively. Since openness itself may be endogenous to changes in the exchange rate, the measures of openness are defined at a sector level as the average openness in the years before 1996 (1993 to 1995), which is kept constant for the whole sample.¹⁷

Finally, the distribution of total pay is highly skewed to the left and contains several extreme values. For this reason we eliminate as outliers observations whenever the pay variable exceeds the value of the top 99% percentile of the sample.¹⁸

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How Costly is Diversity? Affirmative Action in Light of Gender Differences in Competitiveness

Abstract

Recent research documents that while men are eager to compete, women often shy away from competitive environments. A consequence is that few women enter and win competitions. Using experimental methods we examine how affirmative action affects competitive entry. We find that when women are guaranteed equal representation among winners, more women and fewer men enter competitions, and the response exceeds that predicted by changes in the probability of winning. An explanation for this response is that under affirmative action the probability of winning depends not only on one’s rank relative to other group members, but also on one’s rank within gender. Both beliefs on rank and attitudes towards competition change when moving to a more gender-specific competition. The changes in competitive entry have important implications when assessing the costs of affirmative action. Based on ex-ante tournament entry affirmative action is predicted to lower the performance requirement for women and thus result in reverse discrimination towards men. Interestingly this need not be the outcome when competitive entry is not payoff maximizing. The response in entry implies that it may not be necessary to lower the performance requirement for women to achieve a more diverse set of winners

Despite decades of striving for gender equality, large differences still remain between men and women in the labor market. Perhaps most noteworthy is the gender segregation across different types of jobs. While there is substantial horizontal segregation, with women more likely to hold clerical or nurturing jobs and men more visible in manufacturing, the vertical segregation within a sector is particularly striking (Weeden, 2004, and Grusky and England, 2004, Ander, 1998). Across fields men are disproportionately allocated to professional and managerial occupations. In a large sample of US firms Bertrand and Hallock (2001) show that women only account for 2.5 percent of the five highest paid executives.¹ While it may be argued that such segregation is a result of past history, and that these differences will diminish over time, it is noteworthy that women are underrepresented among the people who have the minimum training frequently required for senior management. Only 30 percent of students at top tier business schools are women, and, relative to their male counterparts, female MBA’s are more likely to work in the non-profit sector, work part time, or entirely drop out of the work force.²

It is commonly argued that discrimination, preference differences for child rearing, and ability differences can explain the absence of women in upper level management.³ Recent research suggests that an additional explanation is that women are more reluctant to put themselves in a position where they have to compete against others (see e.g., Gneezy and Rustichini, 2005, Gupta, Poulsen and Villeval, 2005, and Niederle and Vesterlund, 2007, henceforth NV).⁴ For example, NV examines compensation choices in an environment where men and women are equally good at competing. They find that the majority of men select the competitive tournament whereas the majority of women select the non-competitive piece rate. While low ability men are found to compete too much, high ability women compete too little, and few women succeed in and win the tournament.

From the firm’s perspective it is particularly costly if the upper tail of the performance distribution does not enter competitions for jobs or promotions. As explained by B. Joseph White, president of University of Illinois, “Getting more women into MBA programs means better access to the total talent pool for business”.⁵ An additional argument for increasing the number of women in top managerial positions is that diversity in and of itself may benefit the firm.⁶ Indeed US corporations are concerned by their inability to attain and recruit women, and they are increasingly developing programs to improve the number of women employees.⁷

When instituting programs to alter the gender composition in certain jobs it is of course important that we understand how these programs influence behavior. To begin this process, we use experiments to investigate how affirmative action may affect participants’ willingness to compete. Specifically, we consider a quota system which requires that out of two winners of a tournament at least one must be a woman.⁸ We examine the consequences such a system may have on the individual’s decision to compete and thereby on the resulting gender composition of the applicant pool. Accounting for this response we ask how costly it is to secure that women be equally represented among those who win competitions. In particular, how much lower will the performance threshold be for women? How many better performing men will have to be passed by to hire a woman? To what extent will reverse discrimination arise? These questions are particularly interesting in light of the non-payoff maximizing tournament-entry decisions documented by NV.

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Testing Calibrated General Equilibrium Models

Abstract

This paper illustrates the philosophy which forms the basis of calibration exercises in general equilibrium macroeconomic models and the details of the procedure, the advantages and the disadvantages of the approach, with particular reference to the issue of testing "false" economic models. We provide an overview of the most recent simulation-based approaches to the testing problem and compare them to standard econometric methods used to test the fit of non-linear dynamic general equilibrium models. We illustrate how simulation-based techniques can be used to formally evaluate the fit of a calibrated model to the data and obtain ideas on how to improve the model design using a standard problem in the international real business cycle literature, i.e. whether a model with complete financial markets and no restrictions to capital mobility is able to reproduce the second order properties of aggregate saving and aggregate investment in an open economy.

The task of this chapter was to illustrate how simulation techniques can be used to evaluate the quality of a model's approximation to the data, where the basic theoretical model design is one which fits into what we call a calibration exercise. In section 2 we first provide a definition of what calibration is and then describe in detail the steps needed to generate time series from the model and to select relevant statistics of actual and simulated data. In section 3 we overview four different formal evaluation approaches recently suggested in the literature, comparing and contrasting them on the basis of what type of variability they use to judge the closeness of the model's approximation to the data. In section 4 we describe how to undertake policy analysis with models which have been calibrated and evaluated along the lines discussed in the previous two sections. Section 5 presents a concrete example, borrowed from Baxter and Crucini (1993), where we design four different simulation-based statistics which allow us to shed some light on the quality of the model approximation to the data, in particular, whether the model is able to reproduce the main features of the spectral density matrix of saving and investment for the US and Europe at business cycle frequencies. We show that, consistent with Baxter and Crucini's claims, the model qualitatively produces a high coherence of saving and investment at business cycle frequencies in the two continental blocks but it also has the tendency to generate a highly skewed simulated distribution for the coherence of the two variables. We also show that the model is less successful in accounting for the volatility features of US and European saving and investment at business cycle frequencies and that taking into account parameter uncertainty helps in certain cases to bring the properties of simulated data closer to those of the actual data.

Overall, the example shows that simulation based evaluation techniques are very useful to judge the quality of the approximation of fully specified general equilibrium models to the data and may uncover features of the model which are left hidden by more simple but more standard informal evaluation techniques.

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FOREIGN OWNERSHIP AND PRODUCTIVITY DYNAMICS

Abstract

In analyzing the distinctive contribution of foreign subsidiaries and domestic firms to productivity growth in aggregate Belgian manufacturing, this paper shows that foreign ownership is an important source of firm heterogeneity affecting productivity dynamics. Foreign firms have contributed disproportionately large to aggregate productivity growth, but more importantly reallocation processes differ significantly between the groups of foreign subsidiaries and domestic firms.

In recent years a large number of studies have demonstrated the importance of firm heterogeneity for productivity growth, in contrast to earlier growth accounting that traditionally started from the presumption of an aggregate production function based on the representative firm (Bartelsman and doms (2000)). Theoretical models of firm dynamics have formalized the concept of firm heterogeneity and discussed the effects of learning, innovation, investment, entry and exit on firms’ productivity level and evolution (Jovanovic (1982), Pakes and Ericson (1987), Hopenhayn (1992)). Accordingly, recent empirical work has decomposed aggregate productivity into the effects of intra-firm productivity changes, market share allocations among firms with different levels of productivity, and changes in the population of firms. A common finding of this line of research is that large-scale ongoing reallocation of outputs and inputs across individual firms including the entry and exit of firms, contributes to a large extent to productivity growth in industries and countries. Additionally, it is found that this reallocation reflects merely within rather than between industry reallocation (Baily et al (1992), Bartelsman and Drymes (1994), Griliches and Regev (1995), Olley and Pakes (1996), Haltiwanger (1997), Foster et al (1998), Levihnson and Petrin (1999)).

Alternative decompositions have been used in order to assess the contributions of different categories of firms to aggregate productivity growth (Baldwin (1995), Baily et al (1996)), surprisingly however the distinctive contribution of foreign firms and domestic firms have not yet been analyzed. Productivity dynamics within the group of foreign firms and domestic firms can expect to be different given that foreign subsidiaries in host countries are typically found to be more productive than domestic firms (Dunning (1993), Caves (1996)), and that firm dynamics especially entry and exit are reported to differ considerably between foreign and domestic firms (Siegfried and Evans (1994), Geroski (1995)). This paper introduces foreign ownership as an additional source of firm heterogeneity in the analysis of productivity growth and illustrates its importance with reference to a small open country that has attracted large inflows of foreign direct investment.

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THE ELUSIVE COSTS AND THE IMMATERIAL GAINS OF FISCAL CONSTRAINTS

Abstract

We study whether and how fiscal restrictions alter the business cycle features macrovariables for a sample of 48 US states. We also examine the 'typical' transmission properties of fiscal disturbances and the implied fiscal rules of states with different fiscal restrictions. Fiscal constraints are characterized with a number of indicators. There are similarities in second moments of macrovariables and in the transmission properties of fiscal shocks across states with different fiscal constraints. The cyclical response of expenditure differs in size and sometimes in sign, but heterogeneity within groups makes point estimates statistically insignificant. Creative budget accounting is responsible for the pattern. Implications for the design of fiscal rules and the reform of the Stability and Growth Pact are discussed.

Why is it that fiscal constraints appear to make so little macroeconomic difference? We show that the main reason is ability of state governments to work around the rules and transfer expenditure items to either less restricted accounts or to less constrained portions of the government. In addition, the presence of rainy days funds, which are available to all state governments by the end of the sample, effectively allow to limit current expenditure cuts at times when the constraints become binding. Given that constraints apply only to a portion of the total budget, that no formal provision for the enforcement of the constraints exist and that rainy days funds play a buffer-stock role, it is not surprising to find that tight fiscal constraints do not statistically alter the magnitude and the nature of macroeconomic fluctuations.

Our results have important implications for the design of fiscal restrictions. If constraints are imposed to keep government behavior under control, tight restrictions may be the wrong way to go, since they simply imply more creative accounting practices, unless they come together with clearly stated and easily verifiable enforcement requirements. That is to say, tight fiscal constraints are neither a necessary nor a sufficient condition for good government performance. On the other hand, if constraints are imposed to reduce default probabilities or to limit the effects that local spending has on average area wide inflation, and given that their negative macroeconomic effects appear to be marginal, tight constraints with some carefully selected escape route could be preferable.

Is there a lesson to be learned from the results for the reform of the SGP? While Canova and Pappa (2003) have shown that the response of macroeconomic variables to fiscal shocks in the two monetary unions share a number of important similarities, care should be exercised to use our evidence for that purpose. There are at least three reasons which make most of our conclusions dubious in an European environment. First, US state labor markets are sufficiently flexible, people move across states and other margins (such as relative prices) quickly adjust to absorb macroeconomic shocks. Europe is different in this respect and the imposition of tighter fiscal restrictions in the EMU may have completely different effects. Second, since fiscal constraints in the US almost always exclude capital account expenditures, the conclusions we reach are not necessarily applicable to situations where non-golden rule type of constraints are in place. Third, social security, medical and welfare expenditures constitute the largest portion of current account expenditure of European countries, while they are a tiny portion of expenditure of US states (less than four percent). Given that such expenditures are inflexible and, to a large extent, acyclical, direct extension of our conclusions to the European arena should be avoided. Nevertheless, we would like to stress that, while the presence of strict fiscal constraints does not make an important difference for cyclical fluctuations, some fiscal restriction is present in all but one US states. Therefore, none of our conclusions implies the abandonment of some kind of legislated fiscal restraint.

The rest of the paper is organized as follows. The next section describes the empirical model, explains our methodology and compares it with those typically used in the literature. Section 3 presents the procedure used to identify fiscal shocks and to construct fiscal rules. Section 4 describes how indicators capturing deficit and debt restrictions are constructed. Section 5 presents the results and section 6 compares our results to the existing literature. Section 7 concludes.

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Wealth, Financial Intermediation and Growth

Abstract

This paper presents empirical support for the existence of wealth effects in the contribution of financial intermediation to economic growth, and offers a theoretical explanation for these effects. Using GMM dynamic panel data techniques applied to study the growth-promoting effects of financial intermediation, we show that the exogenous contribution of financial development on economic growth has different effects for different levels of income per capita. We find that this contribution is generally increasing with the level of income per capita of the economy, up to a relatively high level of income. This contribution is consistently lower for poor countries; and for some low levels of income per capita it can be negative. We provide a model to account for these wealth effects. The model is a overlapping generations growth model where financial intermediaries implement liquidity risk sharing among depositors. We show that at early stages of economic development, a bank can increase welfare of its depositors only at the cost of lowering investment and growth. However, once the economy has crossed certain wealth threshold, the liquidity role of banks becomes unambiguously growth enhancing. As wealth increases, banks offer improving liquidity insurance, and higher growth; however, for high levels of wealth, growth generated by financial intermediation declines as the economy attains the optimal level of consumption risk sharing.

The central empirical finding of the paper is that the effect of financial development on growth depends in a non linear way on the level of income of countries. This effect varies from negative in low-income countries to positive above a certain wealth threshold; it reaches a maximum among middle-income countries before declining for richer countries. This result is robust to the inclusion of fixed effects and to the control for the growth costs associated with banking crises episodes.

We provide a theoretical explanation for this finding that relies on the growth consequences of the liquidity risk-sharing provided by financial intermediaries at different level of income in a neo-classical context. When countries are poor and returns to long term projects high, even when liquidated, banks perform risk-sharing among agents by increasing the share of long term projects. Risk-sharing implies then lower growth. This result is similar to the growth depressing effect of a reduction in precautionary saving in models with incomplete markets (e.g. Ayagari (2000)). When countries become richer and returns are lower, it becomes optimal for banks to increase risk sharing by using liquid investments to finance early consumption needs. Then risk-sharing implies lower liquidation, higher long term investment and higher growth. In growth accounting terms, the reduction of liquidation corresponds to an increase in total factor productivity that result from bank’s efficient match between the liquidity needs and preferences of agents and the timing of the highest returns of the technologies.

Because financial autarky is also equivalent to a monopolistic banking system and financial intermediation to a fully competitive banking system, our results provide elements in the debate on the optimal timing of domestic financial liberalization. In particular, poor economies could benefit to wait before fully liberalizing their banking sectors.

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Financial Integration, Productivity and Capital Accumulation

Abstract

Understanding the mechanism through which financial globalization affect economic performance is crucial for evaluating the costs and benefits of opening financial markets. This paper is a first attempt at disentangling the effects of financial integration on the two main determinants of economic performance: productivity (TFP) and investments. I provide empirical evidence from a sample of 93 countries observed between 1975 and 1999. The results suggest that financial integration has a positive direct effect on productivity, while it spurs capital accumulation only with some delay and indirectly, since capital follows the rise in productivity. I control for indirect effects of financial globalization through banking crises. Such episodes depress both investments and TFP, though they are triggered by financial integration only to a minor extent. The paper also provides a discussion of a simple model on the effects of financial integration, and shows additional empirical evidence supporting it.

This paper is mainly related to three strands of literature. The literature on growth and development accounting has shown that a large share of cross-country differences in economic performance is driven by total factor productivity (TFP) rather than factor accumulation (physical and human capital).⁴ Hall and Jones (1999) point out that a substantial share of the variation in GDP per worker is explained by differences in TFP and provide evidence that productivity is to a large extent determined by institutional factors. Klenow and Rodriguez-Clare (1997) show that also GDP growth differentials are mainly accounted for by differences in the growth rates of TFP. These results suggest that, if financial globalization is to affect the wealth of nations, it is more likely to do it through its impact on TFP, rather than factor accumulation. This is indeed the main empirical result of the paper.

Several authors suggest that financial development spurs GDP growth by fostering productivity growth, not only by raising the funds available for accumulation. Theoretical papers by Acemoglu, Aghion and Zilibotti (2005), Acemoglu and Zilibotti (1997), Aghion, Howitt and Mayer (2005b) among others show that financial development may relieve risky innovators from credit constraints, thereby fostering growth through technological change. While earlier contributions (e.g., Greenwood and Jovanovic, 1990) suggest that financial development fosters growth simply by increasing participation in production and risk pooling, in the later works the relationship is also driven by advances in productivity. King and Levine (1993), and, in more detail, Beck Levine and Loayza (2000) show evidence of a strong effect of financial development on TFP growth, and only a tenuous effect on physical capital accumulation.

Many papers, extensively summarized in Prasad et al. (2003 and 2006) address the effects of financial globalization on economic growth and volatility, from different perspectives and with various datasets and empirical methodologies. Some studies (for instance, Grilli and Milesi-Ferretti, 1995, Kraay, 2000 and Rodrick, 1998) found that financial liberalization does not affect growth, others that the effect is positive (Levine, 2001, Bekaert et al., 2003 and Bonfiglioli and Mendicino, 2004), yet others that it is negative (Eichengreen and Leblang, 2003). These effects are also shown to be heterogeneous across countries at different stages of institutional and economic development (see Bekaert et al, 2003, Chinn and Ito, 2003 and Edwards, 2001) and countries with different macroeconomic frameworks (Arteta Eichengreen and Wyplosz, 2001). Perhaps surprisingly, very little evidence exists on the effects of financial globalization on the main sources of growth: productivity and capital accumulation. Chari and Henry (2002) find significant effects of equity market liberalization on investments and the Tobin’s Q of listed firms, and conclude that these must be driven by changes in productivity, which they do not explore directly though. Another call for studies on financial integration and productivity is in Prasad et al. (2006).

The remainder of the paper is organized as follows. Section 2 gives a brief overview on growth and development accounting, which leads on to the discussion of my empirical strategy. In section 3, I describe the dataset, with particular attention to the indicators of financial liberalization and banking crises, as well as the construction of the data for physical capital and TFP. Section 4 presents the econometric methodologies, and section 5 reports the results from the estimation of the equations for investments and TFP. Section 6 discusses a simple model that explains the evidence in the previous sections and is consistent with further empirical evidence. Section 7 concludes.

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