Monopolistic Competition, Managerial Compensation, and the Distribution of Firms in General Equilibrium

We develop a general equilibrium model to show how the distribution of matches of heterogeneous quality between …rms and managers, asymmetric information stemming from moral hazard, and monopolistic competition in the product market interact to a¤ect the distributions of …rms and managerial compensation. We exploit the properties of the unique, stationary general equilibrium of the model to derive a number of novel implications for the relations between the …rm size and managerial compensation distributions, and the e¤ects of …rm and product market characteristics on these distributions. (i) Di¤erent determinants of competition have contrasting e¤ects on …rm size and managerial compensation. An increase in the intensity of competition due to a reduction in the entry cost or exit probability decreases expected managerial compensation and the average size of …rms, but increases the number of active …rms. (ii) An increase in the intensity of competition due to an increase in the elasticity of product substitution, however, decreases expected compensation if …rm size is below an endogenous threshold, but increases expected compensation if …rm size is above the threshold. (iii) An increase in productivity risk raises expected managerial compensation and the number of active …rms. (iv) Our general equilibrium model also generates novel implications for the e¤ects of aggregate shocks to the manager-…rm match quality distribution and …rms’productivity levels. An increase in the match quality distribution in the sense of “…rst order stochastic dominance” decreases expected managerial compensation. Expected managerial compensation, the average revenue of active …rms, the average gross pro…t of active …rms decrease with the productivity level, while the number of active …rms increases. We use our theoretical results to develop ten robust empirically testable hypotheses that relate industry characteristics— the entry cost, the exit probability, the elasticity of product substitution, the productivity risk, and the productivity level— to managerial compensation and the number of active …rms. We show support for nine of the ten hypotheses in our empirical analysis. We thank Alex Edmans for very insightful comments and suggestions. We appreciate excellent research assistance from Chunwei Xian. The usual disclaimer applies.