Competition, Relative Performance Evaluation, and Executive Compensation Contracts

Abstract

This paper hypothesizes that the use of relative performance evaluation (RPE) as an incentive mechanism varies positively with the degree of competition a firm faces. I utilize the model proposed by Holmstrom and Milgrom (1987) and Aggarwal and Samwick (1999) to show that the level of competition affects RPE use. While previous research tends to focus on the characteristics of top executives, implying that CEOs are in the driver’s seat in their relationship with firms, this paper examines firm characteristics since CEO characteristics may reflect firm needs and current condition. The tests use two alternative measures of CEO compensation: cash compensation and total compensation. By focusing on firm characteristics, I find evidence that partially supports the hypothesis. The evidence shows strong supports for RPE use in CEOs’ cash compensation.