The Coefficient of Cooperation and CEO Incentive Contracts

It has become increasingly common to reward CEOs based on a firm’s performance relative to that of competitors. Although such incentive contracts can encourage greater CEO effort, there also is concern that they may reduce competition. A duopoly model is developed in which the owner of each firm chooses a relative incentive contract for its CEO that maximizes profit and each CEO makes output market decisions to maximize CEO income. Two important results emerge from the analysis that are not found in the literature. First, the model shows how an incentive contract is directly linked to Cyert and DeGroot’s [[1973] An analysis of cooperation and learning in a duopoly context, Am. Econ. Rev. 63(1), 24–37] “coefficient of cooperation”. The model endogenizes the degree of firm cooperation and clearly reveals how incentive contracts affect competition. Second, the model demonstrates that the optimal incentive contract depends on whether choice variables are strategic substitutes or strategic complements. Thus, the analysis applies to all choice variables, not just output and price as found in previous studies.