Openness, Managerial Incentives and Heterogeneous Firms

This paper examines the effects of trade openness on the optimal incentives firms provide to their managers (and hence firm-level productivity) in the new heterogeneous-firm trade framework. Export market selection and firm heterogeneity are shown to be the key determinants of firm owners’ optimal choices of the incentive contracts, which affect the cost-reduction efforts of their managers. I show that openness to trade generally has a positive impact on the equilibrium power of the incentive contract. This is due to the carrot-and-stick effect resulting from the Melitz-type interfirm reallocation towards ex post lowest-cost exporters, which unambiguously increases the variation of firm profits and thus the value of cost-reduction. Interestingly, whilst falling variable trade cost unambiguously increases managerial incentives, a reduction in fixed trade costs has ambiguous effects on managerial incentives, and might even generate within-firm productivity losses due to the adverse inter-firm reallocation effects. Hence, the model establishes a causal link between the trade-induced Melitz-type reallocation effect and the within-firm productivity changes, both of which have been shown to be important sources of aggregate productivity gains by recent empirical evidence. JEL Classification: F12, F13