Strategic Delegation under Quality Competition

This paper examines strategic manipulations of incentive contracts in a model where firms compete in quality as well as in price. Compensation schemes for managers are based on a linear combination of profits and sales. For a given level of quality, a firm desires to reduce the manager's compensation when product sales increase; this serves as the firm's commitment to raise prices. Nevertheless, in general, a manager has a stronger incentive to produce goods of higher quality if he is compensated according to sales. Therefore, a compensation scheme that penalizes a manager when sales increase may result in products that are inferior to those of its rival. We show that, depending on the nature of quality, a positive weight on sales may be desirable when firms compete in quality and price. Welfare implications are also explored.