“Complementarity and Substitutability of Managerial Incentives: Evidence from China” by Chong-En BAI
University of Hong Kong
Lixin Colin XU
In a series of papers Holmstrom, Milgrom and Roberts have argued that incentives for agents tend to be complementary under certain conditions. A growing body of empirical literature also appears to support this notion. Data constraints, however, have limited the studies to some particular industries or to a selective few aspects in agency contracts. This paper examines the complementarity and substitutability of CEO incentives of more than 300 Chinese state-owned enterprises from a panel data set. The data contain rich information about CEO pay sensitivity; whether the CEO posted performance bond; managerial discretion in production, in employee wage discretion, share of output to sell to the market (versus being required to deliver to the state at lower price); and contract duration. In explaining the interaction of incentives, we extend the framework of Holmstrom and Milgrom (1994) to accommodate the case of multiple signals for the manager's effort for each task. We classify the various incentive instruments into three tasks of CEOs: to pursue current financial performance, to invest for future financial performance, and to work on other activities that yield private benefits. The model then suggests that these three incentive indices should be complementary, and the individual incentives within an incentive index should be substitutes. Our empirical examination confirms these predictions. A side product of getting the conditional correlations is to be able to examine the determinants of the three incentive indices. We find that the determination of CEO incentives for current performance is consistent with the risk-incentive tradeoff hypothesis. The determination of managerial discretion is consistent with the incomplete contract literature that control rights should be matched with the party with superior information and ability. There is also evidence that the government uses contract duration to elicit information.