Optimal contracting with moral hazard and cascading

In this article I identify optimal incentive contracts for managersof firms competing in the product market. Such firms often confrontsimilar decisions and uncertainties. Managers can improve decisionquality by generating private signals through costly effort.However, since signals are likely to be correlated, firms thatdecide later get additional information from the actions ofearlier firms. This impacts effort choice. Decision qualityis also affected if later managers disregard their own signalsand blindly imitate preceding decisions. In a competitive environment,such cascading hurts profits. Contracts that solve both moralhazard and cascading problems typically put more weight on firmprofits, making them expensive. Contacts with more weight ondecision quality are less expensive but result in cascades.Shareholders choose contracts that maximize their net surplus.This results in testable implications about which industriesmay have more convergence in investment choices, greater pay-for-profitsensitivity, larger differences in observed contracts, moreinnovation, larger-size firms, and potential for overcompensation.