Working Paper: CEPR ID: DP8462
Authors: Alessandra Bonfiglioli; Gino A. Gancia
Abstract: We study a dynamic model where growth requires both long-term investment and the selection of talented managers. When ability is not ex-ante observable and contracts are incomplete, managerial selection imposes a cost, as managers facing the risk of being replaced tend to choose a sub-optimally low level of long-term investment. This generates a trade-off between selection and investment that has implications for the choice of contractual relationships. Our analysis shows that rigid long-term contracts sacrificing managerial selection may be optimal at early stages of economic development and when access to information is limited. As the economy grows, however, knowledge accumulation increases the return to talent and makes it optimal to adopt flexible contractual relationships, where managerial selection is implemented even at the cost of lower investment. Better institutions, in the form of a richer contracting environment and less severe informational frictions, speed up the transition to short-term relationships.
Keywords: appropriate contracts; appropriate institutions; development; growth; information; selection
JEL Codes: D8; O40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Economic growth (O00) | Knowledge accumulation (D83) |
| Knowledge accumulation (D83) | Return to talent (D29) |
| Return to talent (D29) | Adoption of flexible contractual relationships (L14) |
| Economic growth (O00) | Transition from long-term to short-term contracts (J41) |
| Better institutions (O43) | Transition from long-term to short-term contracts (J41) |
| Less informational friction (D83) | Transition from long-term to short-term contracts (J41) |
| Managerial ability increases (M54) | Preference for short-term contracts (M55) |
| Long-term contracts maximize investment (D25) | Sacrifice managerial selection (D79) |
| Short-term contracts allow for managerial turnover (J63) | Underinvestment (G31) |