Corporate governance structure and product market competition

Abstract

This article assesses the effects of the competitive structure of a product market on a firm’s corporate governance structure. Our model demonstrates that shareholders strategically determine the corporate governance structure, including the manager’s stock ownership and his controlling power over the firm, in order to maximize their utility in the product market competition. We find that the manager’s stock ownership is lower and his controlling power over the firm is higher when the firm’s product is more profitable or when competition within the product market is more severe. The inefficiency of the wealth transfer from shareholders to the manager also affects the corporate governance structure.

KEYWORDS:

• Corporate governance structure
• managerial ownership
• private benefit of control
• product market competition

JEL classification:

• D86
• G34
• L11

Acknowledgements

We wish to thank the editor (Mark Taylor), two anonymous referees, Sylvain Chassang, Armando Gomes, Radha Gopalan, Todd Gormley, Marina Halac, Byoung-Ki Kim, Woojin Kim, Dong-Ryeol Lee, Vlad Mares, Roni Michaely, Todd Milbourn, Sung Ju Song, Anjan Thakor, Wei Yang and especially David Levine and the late Jong-Won Oh for their helpful comments on our work. Any remaining errors are ours.

Notes

¹ Generally, we can even interpret the first part of the managerial compensation as reflecting the cash flow right of the manager and the second part as reflecting the control right of the manager, following the tradition of terminology described by La Porta et al. (2002). The more profound the difference between these two components, the poorer the firm’s corporate governance appears to be.

² It is not common to refer to the slope of a linear demand curve as the measure of competition between firms. However, as Fershtman and Judd (1987) have demonstrated, $\eta$ denotes the effect of the firms’ production level on the price of the product, and thus, we interpret it as a proportional proxy for the supply elasticity of price $\left(\mathrm{i}.\mathrm{e}.,\frac{\mathrm{\%}\mathrm{\Delta }\mathrm{i}\mathrm{n}p}{\mathrm{\%}\mathrm{\Delta }\mathrm{i}\mathrm{n}s}\right)$ in the industry. Of course, if we extend the model to N firms, then we can use the number of firms in the industry as the measure of competition.

³ We assume $k_i>1$. Otherwise (i.e., $0<k_i\le 1$), the manager’s private benefit-pursuing acts would be socially desirable, rendering any analysis of the agency problem uninteresting.

⁴ That is, ${\alpha }_i({\mathrm{\Pi }}_i-k_i{\beta }_i{I}_i-F_i)+F_i+{\beta }_i{I}_i\ge R$. In the proposed model, the market for managers is given exogenously. If we consider the competition in the market for managers, then the level of the manager’s reservation utility (R) in the model should be endogenously determined.

⁵ Note that our analysis focuses on the strategic behaviours of the manager and shareholders and thus does not consider consumers’ welfare (i.e., social welfare analysis) unlike Brisley, Bris, and Cabolis (2011), who demonstrate that corporate governance slack might induce managers to choose an increased output, leading to a lower market price and greater consumer surplus.

⁶ We derive the condition for the product market equilibrium in the Appendix.

⁷ We show the individual firm’s case in the Appendix.

⁸ Generally, the products of noncompetitive markets tend to be more profitable than the products of competitive markets; thus, we may expect to see higher control rights and lower stock ownership (i.e., higher discrepancy) in noncompetitive markets. However, if we consider the price effect of the product in a noncompetitive market, we obtain the opposite result; Proposition 3 addresses this issue.

⁹ We check the sign of $\frac{\mathrm{\partial }{s}^{\ast }}{\mathrm{\partial }k}$ to get $\frac{\mathrm{\partial }{s}^{\ast }}{\mathrm{\partial }k}=-\frac{c}{4\eta }\beta -\frac{(k-1)c}{4\eta }\frac{\mathrm{\partial }\beta }{\mathrm{\partial }k}<0$ so that the manager will not increase the production level even though his $\beta$ is large. It shows that the effect of $\alpha$ on $s^{\ast }$ is greater than that of $\beta$.

¹⁰ See $SO{C}_i$ in Equation 6.

¹¹ We assume $0<k_i{\alpha }_i<1$.

¹² If the manager’s shares ($\alpha$) increase above a particular threshold level, his fixed pay (F) can have a negative value. In this case, we can interpret that the manager buys shares by giving money (F) to the firm.