Contract competition between hierarchies, managerial compensation and imperfectly correlated shocks

We analyze competition through incentive contracts for managers in duopoly. Privately informed managers exert surplus enhancing effort that generates an externality on the rival. Asymmetric information on imperfectly correlated shocks creates a two-way distortion of efforts under strategic substitutability in effort and a double downward distortion under strategic complementarity in effort. In the first case, as with contracts for R&D activity or small contractual spillovers for quantity and price competition, increasing the correlation of types reduces the polarization of contracts and the differentials in managerial compensations between efficient and inefficient managers. In the second case, as with large contractual spillovers, the opposite occurs.