1. Managerial Effort Incentives and Market Collusion Cécile Aubert University of Bordeaux (GREThA) and Toulouse School of Economics (LERNA) ACLE 2009

2. Main idea Cartel deterrence when owners and managers have different objectives: Managerial incentives may promote collusion… but are needed for incentives.  Interplay between market conduct and effort incentives. Managers may substitute their own effort and collusive behavior, to get high profits.  Usual profitability and sustainability constraints at the cartel level + incentive constraints at the firm level. Impact for internal efficiency ? For antitrust enforcement? Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

3. Some issues in cartel deterrence Literature on Leniency Programs: focuses on corporate LPs Role for an individual LP? Desirability of jail sentences (Wills, 2006, Hammond, 2005)?  Look at incentives of managers and high or middle-level executives. Spagnolo (2000, 2005) : incentive schemes (stocks, bonus plans, etc.) can help sustain collusion at low discount factors. Olaizola (2007), Chen (2008) : delegation to a manager can improve a cartel’s sustainability. Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

4. 1. The model N firms on the same market. In each firm, shareholders offer a (non observable) incentive wage w to a manager. In each period, the manager privately chooses -market conduct K (K = Compete, Monopolize, Deviate ), -and his own effort e. Effort e costs him a disutility  (e) (  (.) strictly convex). The manager can quit in any period. Penalty P if antitrust intervention and shareholders can prove managerial misbehavior. Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

5. The model: Timing Infinite repetition of the game. In each period, 1.Managers choose whether to communicate on collusion, or compete. 2.Each manager chooses K and e (if applicable, he may implement the collusive agreement, or deviates = competes). Discount factor:  for managers,  s for shareholders (If managers stay for short periods, incentive issues are reinforced). A°: after a deviation, all firms revert to competition forever (harshest possible punishment). Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

6. Profits strictly  in e. No direct interaction between effort and collusion Profits are  K = e +  K if all firms have chosen the same K, with  D >  M >  C = 0.  K (e) = e +  K for K=M,D, if one of the other firms has chosen D (deviates), with 0 =  D >  M. The model: Profits Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

7. The antitrust authority investigates and finds evidence of collusion with probability . Fine F on convicted firms, and J on managers if personal liability ( J = 0 otherwise), where the value and impact of J depends on whether monetary liability, or criminal liability / (monetary liability + disqualification). Also possibly -reduced penalties f (< F) to corporate informants in a corporate Leniency Program (LP) -and j=0 (<J) to individual informants, in an individual LP. The model: Antitrust intervention Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

8. 2. Benchmarks: Full information Under full information on e and K, shareholders impose e = e * s.t.  ’(e*) = 1,and w =  (e*) +  J with J = 0 under competition, or no individual liability. Colluding is profitable if  M –  F –  J >  C =0 and sustainable if With a LP, colluding is sustainable if Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

9. Benchmark: Moral hazard on market conduct As profits and effort are observable, so is market conduct (no uncertainty). Idem full information.  Moral hazard w.r.t. collusion decisions has no impact. Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

10. Benchmark: Moral hazard on effort Profits and conduct are observable  so is effort. Shareholders want competition: No incentive issue. Shareholders want collusion: No incentive issue as long as shareholders may deny payment of w unless the required profit level is reached. Otherwise, incentive issue = under-effort + pretend others have deviated: The manager may choose e s.t. e +  M = e* +  M =  (e*,M). Extra cost of collusion: Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

11. 3. Inducing collusion A°: both K and e are private information of the manager. Incentives to compete: Weak unless J is high as more effort is needed under competition. If shareholders can compensate the manager for J only when there is an investigation (“golden parachute”-like mechanism), then little incentive issue. ≠If shareholders must compensate the manager before an investigation occurs, he may want to compete and exert more effort ( e = e M +  M ), if  J >  ( e M +  M ) –  ( e M )(  ). Then, shareholders will require a lower effort level e M than e* to ensure that (  ) does not hold: Inefficient collusion when J high. Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

12. Inducing collusion Incentives to report information: If there is individual LP, to ensure that the manager will not report his information, one must have With a whistle-blowing program, incentives to report are reinforced  Higher compensation costs for shareholders. Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

13. Inducing collusion Incentives to deviate: If he deviate, a manager saves on effort now but get 0 future wages. To avoid that, shareholders may have to pay him an information rent: A manager remains in office after a random investigation ≠ If managerial disqualification or jail, lower discount factor:  is replaced by  (1 –  ). If an individual LP can be used, the manager has more incentives to deviate  His information rent  (by an amount proportional to  J ). Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

14. 4. Inducing competition Assume that shareholders want to induce competition: The manager can save on effort by colluding instead. But if antitrust intervention, penalty P from shareholders, and possibly individual liability.  Participation constraint + incentive compatibility constraint ( we neglect here incentives to deviate ): Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

15. Inducing competition If the incentive constraint (IC) does not bind, e C = e *, and moral hazard has no cost. This is more likely if P large, and if indiv. liability with J large. If the IC is more stringent than participation, shareholders  e C to  the gain of misbehaving: e C < e *. Competition becomes less efficient: Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

16. 5. Summary on antitrust instruments One obtains shareholders decisions by comparing collusive with competitive profits, and checking sustainability.  and J high  competitive effort is closer to first best  collusion is less attractive.(+) Individual liability  more likely that competition is efficient, and  the costs of collusion. (+) LPs reinforce incentives to deviate directly (corporate version) but also via managerial compensation. (+) An individual LP may  the costs of collusion (via the manager’s information rent) but may also make competition less efficient. (?) Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

17. Conclusion Interplay between internal efficiency and market conduct even when they are technically independent. Welfare losses even when no collusion in equilibrium! Individual liability and more frequent antitrust intervention are both useful for cartel deterrence and internal incentives. Individual LP has an ambiguous impact. Managerial disqualification is beneficial. Managers convicted of collusive behavior should not be allowed to receive compensation (as “golden parachutes”). Role for compliance programs (audit). Introduction – Model – Benchmarks – Collusion – Competition – Conclusion

18. Direct interactions between effort and collusion 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.  Interdependence is more favorable to cartel deterrence than the case studied here. The main effects highlighted remain. Introduction – Model – Benchmarks – Collusion – Competition – Conclusion