1. GLOBALIZATION AND THE PROVISION OF INCENTIVES INSIDE THE FIRM Maria Guadalupe Vicente Cuñat Columbia LSE SAE, Zaragoza December 2008

2. Globalization and the provision of incentives inside the firm Recent changes in the Structure of Compensation: executives (and workers ) Increase in performance-related pay: Incentives Murphy, 1999 (Lemieux et al. 2005) Inequality CEO pay and inequality at the top Murphy, 1999; Frydman, 2005; Bebchuck and Fried, 2005 Increase in returns to skill Murphy and Zabojnik, 2004 (Katz and Autor, 1999) Job mobility Huson et al. 2001; Frydman, 2005 (Gottshalk and Moffitt, 1999) Introduction Background Salaries Promotions Conclusions

3. Globalization and the provision of incentives inside the firm Why do firms change wage structures and provide more incentives? Foreign competition, and globalization more generally, can lead to an increase in incentive provision; increased demand for talent. This is at the source of changing wage structures. Ambiguous theoretical predictions on incentive provision. The combined effect of all of them is even more ambiguous. This becomes an empirical question Introduction Background Salaries Promotions Conclusions

4. Globalization and the provision of incentives inside the firm What do we mean by ‘Globalization’ We keep the globalization measure narrow: Changes of foreign competition in domestic markets. We proxy them by: Changes in imports coming into your sector (mean of current and one forward lag) We instrument them with: Exchange rates (contemporaneous and one lag) Tariff changes by sector (one lag) IV approach allows for: Isolate causality from globalization to incentives Avoid possible confounding factors (exports, information…) We do not rely on cross section or trends for identification. Size of the effect is a lower bound Introduction Background Salaries Promotions Conclusions

5. Globalization and the provision of incentives inside the firm What do we mean by ‘Incentives’ Use the broadest possible definition of incentives. Fixed pay Variable pay Wage schedules Demand for talent Individual data: top executives of top US firms. Introduction Background Salaries Promotions Conclusions

6. Globalization and the provision of incentives inside the firm Data description: a) Data on executives Execucomp Dataset: US top managers 5 most highly paid executives in S&P 1500, 1992-2000 Comprehensive information on compensation Financial Information on the firms A Panel: individuals matched with firm variables over time Compensation variable: log of total compensation (includes salary, bonus, stock options valued at B&S, restricted stock, other payments) Firm performance: log of total shareholder returns (incl. equity, dividends) Introduction Background Salaries Promotions Conclusions

7. Globalization and the provision of incentives inside the firm Data description: b) Data on foreign competition Import penetration by MAIN industry (SIC 4) and year: Demeaned at the industry level Import penetration by FIRM and year weighted average of imports –weights are 1991 segment sales Introduction Background Salaries Promotions Conclusions

8. Globalization and the provision of incentives inside the firm Estimating the effect of foreign competition Using the panel and fluctuations in import penetration. Firm weighting: firm specific shocks, independent of firm’s choices. Potential endogeneity problems Are we capturing the effect of an omitted variable correlated with foreign competition? Expected changes in imports incorporated Reverse Causality: Incentives may affect competition (Aggarwal Samwick,1999) Noise from temporary fluctuations and Measurement error Introduction Background Salaries Promotions Conclusions

9. Globalization and the provision of incentives inside the firm Instrumental Variables Average tariff paid by industry and year: Real effective exchange rate by industry: Weights are the importing country share in total US imports in a base year (91-92) (Bertrand 2004) Again use segments to measure at a firm level Current and one lag exchange rate + One lag of Tariff Introduction Background Salaries Promotions Conclusions

10. Globalization and the provision of incentives inside the firm IV have no effect on exports IV have no effect on exports

11. Globalization and the provision of incentives inside the firm IV have no effect on exports Predicted Signs Stand Alone Regressions

12. Globalization and the provision of incentives inside the firm IV have no effect on exports Effective First Stage

13. Globalization and the provision of incentives inside the firm The effect of globalization on the compensation structure Effect on wages A) fixed part: β 1 B) variable part: β 2 W PERF β 0 + β 2 α + β 1 α β0β0 Introduction Background Salaries Promotions Conclusions

14. Globalization and the provision of incentives inside the firm

18. 2. The effect of globalization on the wage ladder ‘Wage ladder’: distance between two wage levels Tournaments and returns to a promotion Import Penetration W ceo exec2 exec5 exec2 exec5 exec3 Introduction Background Salaries Promotions Conclusions

19. Globalization and the provision of incentives inside the firm Measuring the wage ladder Rank individuals in a firm by their wage: D1 (the ceo) to D5 See how the average distance between these two ranks changes CEO wage change Average Distance to the CEO (CEO=omitted cat.) Introduction Background Salaries Promotions Conclusions Change in distance to the CEO

20. Globalization and the provision of incentives inside the firm +trends

21. Globalization and the provision of incentives inside the firm +trends

22. Globalization and the provision of incentives inside the firm

23. 20% of the increase in CEO pay

24. Globalization and the provision of incentives inside the firm Hierarchies effect driven By Prp sensitivities

25. Globalization and the provision of incentives inside the firm 3. Talent Measure change in the ability of the executives hired following the increase in foreign competition: First stage: Calculate individual fixed effect of each executive, controlling for the same variables used in section 1  i measures the wage premium of an executive, not explained by observable variables. Should performance be controlled for or not? Results are robust to both specifications Introduction Background Salaries Promotions Conclusions

26. Globalization and the provision of incentives inside the firm 3. Talent (II) Second stage, regress the individual fixed effect against import penetration, year and firm dummies. Note that the presence of firm dummies makes the estimator be only identified on the basis of movers. Estimate for: Each hierarchy level Average fixed effect within the firm All levels pooled Introduction Background Salaries Promotions Conclusions

27. Globalization and the provision of incentives inside the firm Talent Results Introduction Background Salaries Promotions Conclusions Higher skill moves to Increased competition

28. Globalization and the provision of incentives inside the firm Talent Results Introduction Background Salaries Promotions Conclusions Effect gets amplified By hierarchies

29. Globalization and the provision of incentives inside the firm Conclusion Foreign competition has a number of impacts on how firms organize / compensate workers: Increase in performance pay sensitivities 45% of observed change in the 90s. Increase in dispersion among top 5 execs and Higher CEO pay 20% of increase in CEO pay just from IMP! Higher demand of ability at the top This is all CAUSAL Introduction Background Salaries Promotions Conclusions

30. Globalization and the provision of incentives inside the firm Implications A Causal explanation for: Increase in performance pay sensitivities: inequality A missing link between trade openness and inequality? More active market for talent Increase in pay to CEOs High skill/ decision making (knowledge/management) workers may be more relevant to understand recent labor market dynamics than blue collars. Introduction Background Salaries Promotions Conclusions

31. Globalization and the provision of incentives inside the firm THE END

32. Globalization and the provision of incentives inside the firm Globalization and Competition Theoretical Background – “In two slides” (I) Should competition increase or decrease costly provision of incentives inside the firms? Principal agent models interacting with competition models Vives (2005), Raith (2003), Schmidt (1997), Boone (2002). Ambiguous result within each model. Market stealing elasticity v.s. lower markup More competition leads to more implicit incentives (bankruptcy, profit pressure…) therefore less need for explicit ones (Nickell, 1996; Griffith, 2000; Galdon-Sanchez and Schmitz, 2002; Schmidt, 1997 ) Introduction Background Salaries Promotions Conclusions

33. Globalization and the provision of incentives inside the firm Globalization and Competition Theoretical Background – “In two slides” (II) Firms hierarchies change with competition. Ambiguous theoretical effect (Antras et al 2005), some empirical evidence in favour of “flattening” and higher incentives. Globalization leads to higher demand for talent (Marín & Verdier, 2003) firms should pay more for talent and hire higher talented individuals. More competition should lead to better signal extraction (luck vs. effort) (Hart, 1983; Scharfstein, 1988; and Hermalin, 1992). More weight on relative performance evaluation. Ambiguous effect on performance related pay. Introduction Background Salaries Promotions Conclusions