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Competition and Incentives Lisa Fey University of Munich Klaus M. Schmidt University of Munich Carmen Thoma University of Munich ENDOGENOUS PREFERENCES AND THE BROADER EFFECTS OF COMPETITION KNAW, Amsterdam, 1-2 September 2015

Competition and Incentives There is a general presumption that competition induces firms and individuals to spend more effort and to engage more in innovative activities: Ample anecdotal and case study evidence (Leibenstein 1966, Bloom and van Reenen 2007) Extensive empirical IO literature finds positive or inverted U-shaped relationship between the degree of competition and measures of productivity and innovation (Gilbert 2006) But: Is this a causal relationship? Theoretical literature finds it difficult to explain this effect. Klaus M. Schmidt KNAW Amsterdam 2015 2

Monetary Incentive Effects An increase in the degree of competition affects profits and thereby the marginal returns of investments in cost reduction and innovation. Whether this effect is positive or negative depends on subtle details of the model (Vives 2008): Cournot vs. Bertrand competition Product differentiation Barriers to entry Cost functions Firm heterogeneity, etc. There are no results that offer a robust prediction of the effects of competition. Klaus M. Schmidt KNAW Amsterdam 2015 3

Non-Monetary Effects of Competition Hypothesis: Competition has a direct positive incentive effect that is independent of the monetary incentives it provides. Two lab experiments: Does competition affect effort (investment) choices if monetary incentives are kept constant? Is this a causal effect? Are effort choices strategic complements or substitutes? What is driving these effects? Klaus M. Schmidt KNAW Amsterdam 2015 4

Relation to the Literature (1) Theoretical IO literature: Schumpeter (1942): Innovation requires market power. Arrow (1962): Incentives for innovation stronger with competition. Vives (2008), Schmutzler (2013): Literature is not conclusive. Contract Theory: How does competition affect the optimal incentive scheme? Hart (1983), Holmström (1982): Competition provides information. Schmidt (1997): Threat-of-liquidation effect relaxes limited liability constraint of the manager. Can be interpreted as loss aversion. Klaus M. Schmidt KNAW Amsterdam 2015 5

Relation to the Literature (2) Empirical IO literature: Positive association between competition and innovation/productivity: Geroski (1994), Nickell (1996), Blundell et al. (1999) Inverted U-shaped relationship: Scherer (1967), Aghion et al. (2005). Aghion et al (2005): Degree of competition is endogenous, causal effects difficult to disentangle. Klaus M. Schmidt KNAW Amsterdam 2015 6

Relation to the Literature (3) Experimental literature: Issac and Reynolds (1992): Positive effect of competition Darai et al (2010): Change from Cournot to Bertrand increases cost-reducing investments, but an increase of the number of competitors in Cournot decreases investments. Aghion et al. (2014): With step-by-step innovation competition has a positive incentive effect for firms competing neck-and-neck, but a discouraging effect on laggard firms. Experimental literature on (Tullock) contests: Oversupply of effort (Dechenaux et al., 2015), but effort decreases with number of contestants. In all of theses studies competition affects monetary incentives! Klaus M. Schmidt KNAW Amsterdam 2015 7

Outline of the Presentation 1. Introduction 2. Experiment 1: Competition induces oversupply of effort Simultaneous effort choices Monetary incentives in equilibrium are the same in all treatments 3. Experiment 2: Effort choices are strategic complements Sequential effort choices Decision problems are identical (except for the existence of a competing person) in all treatments. 4. Conclusions Klaus M. Schmidt KNAW Amsterdam 2015 8

2. Simultaneous Investments Experimental design: Manager has to invest effort in risky project Effort e increases probability of success: p(e) Cost of effort is monetary: c(e)=2e Klaus M. Schmidt KNAW Amsterdam 2015 9

Treatments (1) 1) Monopoly Treatment: Manager receives a bonus if he is successful π 290 if success = 310 + B 2 e with B = 0 if no success M M M One person decision problem Optimal effort level for a risk-neutral decision maker is e=40. Klaus M. Schmidt KNAW Amsterdam 2015 10

Treatments (2) 2) Duopoly Treatment: Two managers make effort choices simultaneously. Each manager receives a bonus depending on his own success and success of competing firm: 480 if i succeeds and j fails D D D 200 if i and j both succeed i = 210 + Bi 2 ei with Bi = 80 if i and j both fail 0 if i fails and j succeeds Strategic decision problem. π Efforts are strategic substitutes. Optimal effort level for a risk-neutral decision maker in Nash equilibrium is e=40. Klaus M. Schmidt KNAW Amsterdam 2015 11

Treatments (3) 3) Oligopoly Treatment: Four managers make effort choices simultaneously. Each manager receives a bonus depending on his own success and successes of competing firms: 760 if i succeeds and all others fail 350 if i and one other manager succeed O O O 190 if i and two other managers succeed π = 210 + Bi 2 ei with Bi = 90 if all managers succeed 40 if i all managers fail 0 if i fails and at least one other manager succeeds Optimal effort level for a risk-neutral decision maker in Nash equilibrium is e=40. Klaus M. Schmidt KNAW Amsterdam 2015 12

Results Result 1: In all treatments subjects invest significantly more effort than predicted by Nash equilibrium Klaus M. Schmidt KNAW Amsterdam 2015 13

Results Klaus M. Schmidt KNAW Amsterdam 2015 14

Results Result 1: In all treatments subjects invest significantly more effort than predicted by Nash equilibrium Result 2: (a) The average effort invested in the competition treatments in significantly higher than the average effort in the monopoly treatment. (b) The average effort in the duopoly treatment is higher than the average effort in the oligopoly treatment but the difference is not significant. Klaus M. Schmidt KNAW Amsterdam 2015 15

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Discussion 1. Strategic interaction in competition treatments: Players may have mistaken beliefs about effort choices of competitors. Efforts are strategic substitutes. To explain behavior players must believe that competitors invest almost nothing. They should learn over time that this is not the case. 2. Players may be risk averse: Competition treatments involve more risk. Risk averse players should invest less in competition treatments than in monopoly treatment. 3. Social interaction in competition treatments: Envy, inequity aversion, or reciprocity may affect behavior. Joy of winning may be higher if a subject wins against another subject than against nature. Klaus M. Schmidt KNAW Amsterdam 2015 20

3. Sequential Investments Experimental design: Manager has to choose probability of success Duopoly Treatment: Manager 1 moves first. Manager 2 observes the effort choice of M1 and moves second. Klaus M. Schmidt KNAW Amsterdam 2015 21

Treatments (1) 1) Sequential Duopoly Treatment (DUO-SEQ): π Manager 1 chooses effort p 1. Manager 2 observes p 1 and chooses p 2. 200 if i succeeds and j fails 100 if i and j both succeed = 100 + B e( p ) with B = 100 if i and j both fail 0 if i fails and j succeeds D D D i i i i i Manager 2 does not have to form beliefs about p 1 It is a dominant strategy for each manager to choose p i =40. Strategies are neither substitutes nor complements. Klaus M. Schmidt KNAW Amsterdam 2015 22

Treatments (2) 2) Monopoly Treatment (MONO-SEQ): Manager M chooses effort e. Bonus depends on success and market conditions (mc). 200 if M succeeds and favorable mc M M M 100 if M succeeds and unfavorable mc π i = 100 + B e with B = 100 if M fails and favorable mc 0 if M fails and unfavorable mc Favorable market conditions are payoff equivalent to failure of competing manager in DUO-SEQ. Probability of favorable mc is equal to p 2 in DUO-SEQ. Decision problems in DUO-SEQ and MONO-SEQ are identical except for the presence of a competing manager. Klaus M. Schmidt KNAW Amsterdam 2015 23

Results Result 3: (a) In both treatments subjects invest significantly more effort than predicted by dominant strategy equilibrium. (b) In the duopoly treatment the second duopolist invests 53.6 on average, which is more than the average investment of the monopolist of 52.6. However, the difference is not statistically significant. Klaus M. Schmidt KNAW Amsterdam 2015 24

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Results Result 4: (a) The probability of success chosen by duopolist 2 depends positively on the probability chosen by duopolis 1, i.e. efforts are strategic complements. (b) The probability of success chosen by the monopolist depends negatively on the probability of unfavorable market conditions. More effort of the competitor induces a duopolist to work harder, but payoff equivalent adverse market conditions induce a monopolist to be more complacent! Klaus M. Schmidt KNAW Amsterdam 2015 29

Conclusions 1. Competition has a causal effect on behavior that goes beyond the monetary incentives it provides. Experiment allows us to keep monetary incentives constant. Random assignment of subjects to treatments rules out self-selection effects. 2. Experiment 1 shows that competition induces additional effort. 3. Experiment 2 shows that competition turns effort choices in strategic complements. 4. So far these non-monetary effects of competition have been ignored. They may contribute to the explanation of the positive relationship between the degree of competition and measures of productivity and innovation. 5. Further research is required to pin down by which behavioral mechanisms competition affects incentives. Klaus M. Schmidt KNAW Amsterdam 2015 30