Competition, Quality and Managerial Slack

We consider the role of product market competition in disciplining managers in a moral hazard setting. Competition has two effects on a firm. First, the expected revenue or the marginal benefit of effort declines, leading to weakly lower effort. Second, the cost of inducing high effort increases (decreases) if competition increases (decreases) the probability of failure at a firm. Both effects imply a change in the optimal level of effort as competition increases. The manager in our model enjoys slack if he supplies low effort in equilibrium. We show that, if competition increases the probability of failure, managerial slack increases with competition. We reconcile this result with contrary empirical findings by pointing out that what has been empirically tested is changes in slack in response to exogenous changes in the private benefit of low effort, rather than the level of managerial slack itself.