MANAGERIAL AND DECISION ECONOMICS

Manage. Decis. Econ. 26: 499–512 (2005)

Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/mde.1237

Strategic Managerial Incentives Under

Adverse Selection
Michel Cavagnac*
University of Limoges, GREMAQ and LEERNA-Toulouse I, France

We extend the strategic contract model where the owner designs incentive schemes for her
manager before the latter takes output decisions. Firstly, we introduce private knowledge
regarding costs within each owner–manager pair. Under adverse selection, we show that
delegation involves a trade-off between strategic commitment and the cost of an extra
informational rent linked to decentralization. Which policies will arise in equilibrium? We
introduce in the game an initial stage where owners can simultaneously choose between control
and delegation. We show that if decision variables are strategic substitutes, choosing output
control through a quantity-lump sum transfer contract is a dominating strategy. If decision
variables are strategic complements, this policy is a dominated strategy. Further, two types of
dominant-strategies equilibrium may arise: in the first type, both principals use delegation; in
the second one, both principals implement delegation for a low-cost manager and output
control for a high-cost one. Copyright # 2005 John Wiley & Sons, Ltd.

INTRODUCTION tre and López-Cuñat (2001) in the context of

Following Vickers (1985), the literature on com-
petition in oligopolies has developed the idea that
the separation of ownership and management
within a firm may be a good thing for the owner
because a non-profit-maximizing manager may
bring about higher profits than a profit-maximiz-
ing one. We find two variants in this literature. The
first one is the strategic contract model where the
owner designs incentive schemes for her manager
before the latter takes decisions. In duopoly
contexts, Vickers (1985), Fershtman and Judd
(1987) and Sklivas (1987) base the contracts on
profit and sales. This type of contract is also used
by Barros (1995) in a situation of mixed duopoly
(private firm–public firm) and by González-Maes-
*Correspondence to: Université des Sciences Sociales-Gremaq,
Manufacture des Tabacs - Bât. F, 21 Allée de Brienne, 31042
Toulouse Cedex, France.
E-mail: michel.cavagnac@univ-tlse1.fr
oligopoly including the possibility, for the firms, to
constitute cartels. Fershtman et al. (1991) incor-
porate in the contract the realization of a given
objective (target compensation). In Salas (1992),
the contract takes into account both the profit
brought by the manager and the profits achieved
by the other firms. In Labory (1997), it is a system
of promotion that is used to affect the managers’
incentives in a strategic way. The second variant is
the strategic organization model. Indeed, commit-
ment to a behavior different from profit max-
imization can also be achieved through the
internal organization of the firm. For example, in
Fershtman (1985) and Sen (1993), each firm has
two managers who jointly decide on the produc-
tion level, after the owner has determined the
bargaining power of each one.1 In Gal-Or (1993),
it is once more in terms of strategic commitment
that the principal chooses, for the operations of
production and distribution, between depart-
mentalization and integrated management.

Copyright # 2005 John Wiley & Sons, Ltd.

500 M. CAVAGNAC
Considering multi-product firms, Fauli-Oller and
Giralt (1995) base the remuneration contracts, in
each division of the firm, on the profit achieved by
the other divisions.2 The external organization of the
firm can constitute a strategic variable as well. This
is the case in Bonanno and Vickers (1988) where, for
the sale of her products, the principal chooses
between a vertical structure and a vertical integra-
tion (direct selling). In Gal-Or (1992) and Barros
(1997), it is once more the search for a strategic
commitment that determines the choice between
proceeding (or not) to the vertical integration of
specific production operations. Let us note that in
other domains, such as international competition,
some analogous opportunities exist. The taxes and
subsidies applied to the firm by the principal (the
government) replace there the incentives schemes of
the managers’ rewarding contracts above.3
Let us stress that when the individual owner–
manager relationship is examined within a sym-
metric competitive framework, that is when each
owner–manager pair can make use of strategic
contracts, the positive effect of delegation is not so
clear. For example, Fershtman and Judd (1987)
and Sklivas (1987) show that the delegation result
critically depends upon the nature of the competi-
tion in duopoly (in fact, upon the nature of the
decision variables). On one hand, in the Cournot-
quantity competition case (strategic substitute
decision variables), at the incentive equilibrium,
each owner gives her manager a positive incentive
for sales, therefore motivating him towards a high
production level. As a result, firms end up
achieving lower profits than they would have in
the usual Cournot outcomes. On the other hand,
when firms compete in a Bertrand way via
differentiated products (strategic complement de-
cision variables), at the incentive equilibrium, each
owner gives her manager a negative incentive for
sales, therefore encouraging high prices. Conse-
quently, firms achieve higher profits than they
would have in the usual direct price competition.
However, although comparing profits earned by
strategic delegation contracts with profits supplied
by a direct control of managers is an interesting
question in itself, it does not answer the question
which organizational structure arises in equili-
brium. Even if each owner prefers, say, the
outcome where both owners use strategic delega-
tion to the outcome where both owners directly
control managers, it does not follow that this type
of organization will be reached in a non-coopera-
Copyright # 2005 John Wiley & Sons, Ltd.
tive setting. This is the first extension brought by
our work: we make the organizational choice
endogenous. Hence, we introduce in the game an
initial stage where owners can simultaneously
choose (with commitment) between control and
delegation. Our game is a differentiated duopoly
game. Firms compete in quantities. Since the result
of delegation appears to be closely related to the
nature of the decision variables, we consider that
goods may be either substitutes (strategic substitute
decision variables) or complements (strategic com-
plement decision variables). It is well known (e.g.
Gal-Or, 1985) that the first player that moves earns
the highest (lowest) profits when decision variables
are strategic substitutes (complements). However,
at the initial stage of our game, choosing direct
control only will eliminate the possibility of being a
follower and choosing to delegate only will exclude
the possibility of leading.
The main motivation for this paper stems from
the informational context. Most of the studies
quoted above are based on the assumption of
complete information. However, this may be a
strong assumption insofar as the delegation of
authority is often the source of asymmetries of
information. Indeed, it can be very expensive for
the principal to control with precision the actions
undertaken by her manager. Besides, the manager
is closer to the realities of the market and to the
organization of production; she has often private
information. Here, we introduce private knowl-
edge by considering that managers have better
information than owners with respect to costs.
More precisely, in our model, each manager knows
her own costs (which can be of two types) but none
of the other participants in the game do. It follows
that within each owner-manager pair, we have a
situation à la Baron–Myerson (1982). In this sense,
we are within the usual principal–agent frame-
work. The crucial difference, however, is that we
have to consider agency problems for two princi-
pal–agent pairs in competition. There are still few
studies that exploit, in situations of competition,
the results obtained by the theory of the agency:
Gal-Or (1992,1993), Barros (1997) and Labory
(1997). In these works, strategic effects on compe-
tition are the result of the internal organization
chosen for the firm. In our model, the owner may
manage her firm so that she keeps the control on
output decisions. Alternatively, the owner may
organize delegating that provides strategic oppor-
tunities. In the latter case, in the spirit of the
Manage. Decis. Econ. 26: 499–512 (2005)
 STRATEGIC MANAGERIAL INCENTIVES
strategic contract model, she uses rewarding
schedules in order to gives strategic incentives to
her manager.
We show that the assumption of asymmetry of
information brings all its specificity in the search
of a strategic advantage through managers’
incentives. Indeed, introducing private knowledge
strongly modifies the strategic background.
Firstly, using a traditional incentive scheme (linear
in profit and sales) makes no longer sense facing
unobservable costs. Secondly, considering a simple
rewarding contract is no longer sufficient; here, to
elicit truthful revelation of manager’s cost, the
owner must offer a menu of agreements. Thirdly,
the strategies-space turns out to be enlarged:
through the screening contract, an owner can still
choose to implement delegation as well as direct
control whatever her manager’s type; but, she
must here consider additional policies by which
she implements delegation for one type of manager
alone and direct control for the other type. The
fourth aspect concerns the competitive framework
itself. Costs are managers’ private information and
there is no signaling from owners, either through
the initial choice of a policy, or through the
corresponding contracts. Thus when outputs must
be chosen, each owner (if direct control) or
manager (if delegation) is playing a Bayesian game
where she knows neither the rival’s cost nor the
agreement that has been chosen within the rival
owner’s menu. Let us stress that without signaling,
the revelation principle can be applied in our
competitive framework.
The main results rely on informational rents. The
ability of a low-cost manager to mimic a high-cost
one forces each owner to give up a rent to her low-
cost manager in order to induce cost revelation. In a
control policy, the amount of this rent is equal to
the comparative-cost advantage of the efficient
manager over the inefficient one, when the former
mimics the latter by producing the same output. In
a delegation policy, managers can choose their
outputs, such that, when the efficient manager
wishes to mimic the inefficient one, she produces a
higher output than the latter; it follows that an extra
informational rent arises. Therefore, delegation
involves a trade-off between strategic commitment
and inherent additional rent cost. It follows that if
goods are substitutes, choosing output control
through a quantity-lump sum transfer contract is
a dominating strategy. If goods are complements,
this policy is a dominated strategy. Further, if goods
Copyright # 2005 John Wiley & Sons, Ltd.
501
are complements, two types of dominant-strategies
equilibrium may arise. In the first type, both
principals use delegation; in the second one, both
principals implement delegation for a low-cost
manager and output control for a high-cost one.
The paper is organized as follows. The next
section describes the model in more detail. In the
section following this, we solve the relevant
duopoly subgames using backward-induction.
The optimal incentive contracts are determined
in the subsequent section. The penultimate section
enlarges the principals’ strategic space by adding
open policies in which principals are not limited to
the binary choice: control or delegation. The final
section concludes this work and discusses the
necessary extension of the model.
THE MODEL
We consider a differentiated duopoly facing a
linear demand structure.4 In the region of quantity
space where prices are positive, inverse demands
are given by (with a>0 and b>|g|50):
pa ¼ a
bqa
gqb and pb ¼ a
gpa
bqb ;
where pi and qi are, respectively, the price and the
amount of the good produced by firm i (i=a,b).
The consumers’ willingness to pay for good i=a,b
is always decreasing in quantity and decreases
(increases) with the quantity of the other good
when g>0 (g50). Hence, goods are substitutes,
independent, or complements according to the sign
of g. The two firms compete in quantities and the
functional form of inverse demands is common
knowledge.
In our model, on the production side, we have a
principal and a manager for each firm. By
principal we mean a decision-maker whose objec-
tive is to maximize the profits of the firm; manager
refers to an agent whom the principal hires to
make real-time decisions concerning output. The
quantities sold are commonly observable. More-
over, it is common knowledge that each manager
bears a private constant unit-cost which can take
two values: c1>0 with probability n1 and c2=0
with probability n2=1
n1. (Because we can choose
a freely in inverse demands, we normalize c2 to
zero.) Within the model, the discrepancy in costs
between managers is essential; therefore, we will
use the redundant but more explicit notation:
Dc  c1
c2 (Dc>0 and small enough to remain
Manage. Decis. Econ. 26: 499–512 (2005)