A Strategic Rationale for Imperfect Pro...t Measures

In models by Fershtman and Judd (1987) and Sklivas (1987), ...rms competing in quantities bene...t strategically from commiting to managerial incentives that are biased toward revenue maximization. Little empirical evidence has been produced in support of these models, and their assumption that incentive contracts are observable has been criticized as unrealistic. This paper proposes an alternative model in which ...rms competing in strategic substitutes commit to using less precise pro...t measures, which biases the optimal unobservable contract towards revenuemaximization. This model performs better empirically. Firms that compete in strategic substitutes choose less precise pro...t measures across six di¤erent measures. Firms with less precise pro...t measures in turn have stock returns and thus managerial incentives that are driven more by revenue growth. Controlling for this channel, ...rms that compete in strategic substitutes do not directly modify their managerial incentives in the direction predicted by observable-contract models; on the contrary, having commited to more revenue-driven stock returns, they actually undo part of the resulting incentive bias using their non-stock incentives, which is consistent with unobservable contracts.