Product Market Competition and Organizational Slack under Prot-Target Contracts Salvatore Piccolo y Marcello DAmato z Riccardo Martina x January 18, 2008 Abstract In a framework la Martin (1993) we introduce a common component in the managers private information in order to address three related questions: What is the impact of con- tracts that reward managers on the basis of realized prots on rms productive and allocative e¢ciency relative to cost-target contracts? How do these contracts shape the relationship be- tween competition and organizational slack? Can we then explain the existing evidence of an inverted-U shaped relationship between competition and cost-reducing activities, as docu- mented in Aghion et al. (2005)? We show that prot-target contracts introduce a horizontal (contractual) externality between the competing rms that mitigates organizational slack and improves upon productive e¢ciency relative to cost-plus mechanisms. Moreover, when exec- utive compensations are conditioned on prots, an inverted-U shaped relationship between product market competition and managerial e/ort obtains. Finally, we also show that when contractual instruments are endogenous, e.g., when shareholders can choose between prot- and cost-target rules, the equilibrium with prot-target contracts always exists and is the only one that survives to standard renements. Keywords: competing-contracts, product market competition, X-ine¢ciency JEL Classication: D82, L13, L22. We are indebted to David Martimort for many helpful suggestions and comments. We also thank Priyo Baner- jee, Paolo Bertoletti, Jakub Kastl, Ismo Linnosmaa, Albert Ma, Greg Pavlov, Clara Poletti, Luci Quesada, Bill Rogerson, Mike Whinston and all participants to seminars held at CSEF-IGIER Summer Symposium in Economics and Institutions (Anacapri, 2005), EEA Meeting (Amsterdam, 2005), EARIE (Valencia, 2007), Northwestern Uni- versity and University of Pavia. We are grateful to a coeditor and two anonymous referees for useful comments. A previous version of this paper was circulated under the title Competitive Pressure, Incentives and Managerial Rewards. Financial support from MIUR (Fondi PRIN 2004) is gratefully acknowledged. Errors are ours. y DPTSE- University of Naples Federico II, CSEF, and Toulouse School of Economics - GREMAQ. z DISES- University of Salerno and CSEF. x DPTSE-University of Naples Federico II and CSEF. 1