Relative Performance Evaluation in an Oligopoly

In an oligopoly, firms strategically interact. This implies that their profits are interdependent. The Controllability Principle, therefore, argues that managerial performance should be evaluated based on both own-firm’s and rival-firms ’ profits, as such evaluations (i.e., a form of relative performance evaluation, RPE) lead to efficient strategic interactions. But one firm’s profitability is usually affected by random factors that also affect other firms ’ profitability. These random factors can be filtered out from managers ’ incentive contracts by using RPE, resulting in efficient risk-sharing in accordance with the Informativeness Principle. Thus, managers ’ strategic-interaction and risk-sharing incentives are two salient features of RPE. Importantly, however, because they stem from two distinct economic forces (controllable performance and efficient risk-sharing), each can occur in the absence of the other. Consequently, recognizing these two sets of incentives separately in the context of efficient incentive contracts, we show that the real issue concerned with the RPE puzzle is why and how, rather than whether or not, RPE is employed in executive pay. An important implication is that as a firm’s price contains information about other firms in an industry due to inter-firm dependencies, its use in executive pay is already a form of RPE.