Abstract

We consider the incentive characteristics of optimal linear contracts based on relative performance evaluation (RPE) for managers undermoral hazard in imperfectly competitive product markets. Each contract influences the quantity choices of all competing agents causing contract externalities that affect the principals ’ contracting game. We analyze the relations between the optimal extent of RPE and several firm and market characteristics, especially allowing for heterogeneous firm characteristics and imperfectly correlated firm profits. We find non-monotonic comparative static results, which yield an explanation for the mixed empirical results in the literature and may help to improve the empirical evidence regarding RPE.