Managerial Effort Incentives and Market Collusion Cécile Aubert University of Bordeaux (GREThA) and Toulouse School of Economics (LERNA) CLEEN Workshop – June 13, 2008

Main idea The objectives of owners and those of decision-makers within a firm may not be aligned. Obtaining high profits without misbehaving (e.g., colluding) requires more effort from managers (and high executives) – which is costly. When effort is private information, managers may substitute effort and collusive behavior. Does this faciliate collusion? Can it be prevented by honnest shareholders? What impact for antitrust enforcement? Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

Internal conflicts of interests Fraud is widespread even at top level (cf. Price Waterhouse Cooper, 2008). -Shareholders cannot fully control top executives; -Yet they may also be able to induce misbehavior with highly demanding targets and incentive wages. This applies to many types of misbehavior, including collusion. Impact for cartel deterrence and liability? Examine the impact of antitrust tools along the way. Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

Some issues in cartel deterrence 1. New versions of Leniency Programs (LP) (1993 in the US, 1996, 2002 and 2006 in the EU): apparently quite successful. LPs distinguish corporate and individual leniency. Most of the economic literature has focused on corporate LPs (e.g., Motta and Polo, 2003, Spagnolo, 2004, Aubert, Rey and Kovacic, 2006, Harrington, 2008,…). What is the exact role of an individual LP? In the US, the use of effective internal compliance programs grants a reduction in liability. One must open a little the black box of the firm. Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

Some issues in cartel deterrence 2. Aubert, Rey and Kovacic (2006) suggest rewards for informed employees reporting evidence as to collusion. What if the informed employee is the decision-maker? Perverse incentives? 3.Desirability of jail sentences? Traditionally viewed as inefficient by economists, although some practitioners see them as quite effective (e.g., Hammond, 2005). Wills (2006). 4.Is managerial disqualification (as imposed in the UK) useful (given that managers in colluding firms may be compensated for this risk?). Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

Some literature on managerial incentives and collusion Spagnolo (2000, 2005) has shown how particular, usual, incentive schemes for managers (stocks, bonus plans, etc.) can help sustain collusion even at very low discount factors. Chen (2008) studies how delegation to an agent can improve a cartels sustainability. Here, different issue: interplay between market conduct and effort incentives moral hazard on two variables. Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

Outline 1.The model 2.Benchmarks 3.Managers incentives under asymmetric information 4.Antitrust instruments 5.Conclusion Remark: abstract from moral considerations, and from coordination issues between firms. Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

1. The model N firms are on the same market. In each firm, shareholders offer a (non observable) incentive wage w to a manager (or top executive). In each period, the manager privately chooses -the firms market conduct K (K = C, M, D ), -and his own effort e (e in [0,1]). Effort e costs him a disutility (e) ( (.) strictly convex). The manager can quit in any period few punishment opportunities. Penalty P if antitrust intervention and shareholders can prove managerial misbehavior? Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

The model: Timing In each period, 1. Managers first choose whether to meet and communicate on to a collusive agreement (if one refuses, competition). Communication leaves evidence. 2. Each manager is free to implement the collusive agreement, or deviate. He chooses market conduct and effort. A°: after a deviation, all firms revert to competition forever (harshest possible punishment). The game is repeated infinitely. Discount factor: for managers, s for shareholders (if managers stay for short periods, incentive issues are reinforced). Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

Profits strictly in e and are - K (e) if all firms have chosen the same K, - K (e), for K=M,D, if one of the other firms has chosen D. If several firms deviate, competition: D (e) = C (e). One has D (e) > M (e) > C (e) (= D (e)) > M (e). Special case: No direct interaction between effort and collusion K = e + K with D > M > C = 0. (e.g., effort affects fixed costs). The model: Profits Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

The antitrust authority (AA) investigates and finds evidence of collusion with probability. AA imposes a fine F on convicted firms, and possibly a personal fine or jail sentence J on managers in convicted firms (if personal liability). It can also offer -reduced penalties f (< F) to corporate informants in a corporate Leniency Program (LP) and j (<J) to individual informants, in an individual LP, -rewards r to individual informants in a Whistleblowing Program (WP). The model: Antitrust intervention Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

2. Benchmarks: Full information Shareholders impose e = e * s.t. (e*) = 1 (whatever K), w = (e*) + u with u = J, if personal liability + K = M,D, (e.g., bonus / parachute if leave after AA case), and u = 0 otherwise. Colluding is profitable if M – F – u > C and sustainable if Personal liability the profitability of collusion. Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

Benchmark: Unobservable effort and K are observable so is e. Shareholders want competition: No incentive issue. Shareholders want collusion: Incentive issue = false deviation from others: the manager gains in the short run (if small) by choosing e s.t. e + M = e* = (e*,M). Here limited punishment opportunities (0 at most). A colluding firm should pay an information rent: w > w* = (e*), with w s.t. Extra cost of collusion in each period: Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

Benchmark: Unobservable market conduct As and e are observable, so is K. Under collusion, shareholders must compensate the agent in case of individual liability, as under full information. In the absence of moral hazard with respect to effort, moral hazard w.r.t. collusion decisions has no impact (this might not hold if non-deterministic link between and K ). Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

3. Managers incentives under moral hazard A°: both K and e are private information of the manager. Case 1: shareholders want to induce collusion: The logic of incentive constraints is similar to the benchmark cases: the manager must exert additional effort if he competes instead of colluding. If there is individual leniency (and legal protection so P =0 then), an incentive constraint arises: A manager would report his information if Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

Managers incentives: Inducing collusion (2) To prevent information reports, shareholders should offer which is benchmark wage (information rent). If in addition managerial disqualification, should be replaced by u = (1 – ). Individual leniency and managerial disqualification are complements and make collusion less profitable. Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

Managers incentives: Inducing competition (1) Case 2: shareholders want to induce competition: The manager can save on effort by colluding instead. But if antitrust intervention, penalty P from shareholders, and J if individual liability. Let u = J with individual liability, u = 0 otherwise. Participation constraint + incentive compatibility constraint ( we neglect here incentives to deviate ): Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

Inducing competition (2) If the incentive compatibility constraint (IC) does not bind, e C = e *, and moral hazard has no cost. This is more likely if P large, and if there is individual liability with J large. If the IC is more stringent than participation, shareholders e C to the gain of misbehaving: e C < e *. Due to double moral hazard, competition becomes less efficient: (note that e C with ) Introduction – Model – Benchmarks – Managers – Antitrust – Conclusion

4. Antitrust instruments Shareholders choice: Compare collusive profits with competitive profits, and check sustainability. When managers have incentives to collude rather than compete, the lower effort necessary to induce competition makes collusion more attractive. Individual liability -makes it more likely that competition is efficient, -and increases the costs of collusion. Leniency programs reinforce incentives to deviate -directly (corporate version) -but also via managerial compensation (no need to compensate the manager for individual liability when deviation). Introduction – The model – Benchmarks – Managers – Antitrust – Conclusion

Whistleblowing programs Under collusion: Impact even under full information on e and K: w = (e*) + r(1 – ) with r = antitrust bonus to informants. If the firm deviates, the manager will ask for the full reward r ( complementarity LP / WP as shareholders will not pay r if deviation + LP). Let u = f if LP, u = F otherwise.Collusion is sustainable if Under competition: Perverse incentives if asym. information on K? Limit rewards size? Reputation issues. Denouncing is highly visible + not easily justifiable as in the interests of the firm. Introduction – The model – Benchmarks – Managers – Antitrust – Conclusion

Direct interactions between effort and collusion We have seen an interplay between effort and market conduct even when they are technically independent. If the impact of effort increases with quantities, effort incentives make deviations more attractive. To induce collusion, shareholders must induce a lower effort. The costs of collusion entail lower efficiency. This technical interdependence is more favorable to cartel deterrence than the one studied here. The main effects highlighted remain however. Introduction – The model – Benchmarks – Managers – Antitrust – Conclusion

Conclusion Individual liability and more frequent antitrust intervention both improve cartel deterrence and internal incentives with competition. Individual leniency has an ambiguous impact. Managerial disqualification is beneficial when coupled with individual leniency. And managers convicted of collusive behavior should not be allowed to receive golden parachutes. Whistleblowing programs may raise new incentive issues, yet reputation concerns are likely to mitigate these (as well as the efficiency of the WP…). Longer employment duration facilitates both collusion and efficient competition. Employees may not quite know what is illegal (compliance programs?). Introduction – The model – Benchmarks – Managers – Shareholders – Conclusion