Managerial Heterogeneity, Organizational Capital and
Firm Performance.
Wouter Dessein, Andrea Prat
Columbia University
November 2016
Wouter Dessein, Andrea Prat (Columbia)
Managerial Heterogeneity
November 2016
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What are we trying to understand?
Large unexplained di¤erences in performance across …rms (Syverson’s
2011)
Possibly due to management and/or managers
But everything is endogenous
management practices
managers
performance
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Managerial Heterogeneity
November 2016
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Three perspectives on organizational performance
1
Optimal contingent design
2
Organization-centric perspective
3
Manager-centric perspective
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Managerial Heterogeneity
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1. Optimal Contingent Design
Often unspoken, default perspective of economists
Managers and managerial practices are production factors that …rms
can purchase
Firm choose them optimally keeping into account costs and bene…ts
Milgrom-Roberts (1990, 1995): complementarities
Lucas (1978): better managers are more expensive
Prediction: Once we control for other di¤erences, management should
not be correlated with pro…tability.
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Managerial Heterogeneity
November 2016
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2. Organization-centric view
Ichniowski et al. (1997), Bloom Van Reenen (2007)
Companies in the same industry/region choose highly di¤erent
organizational forms
Some organizational forms are systematically correlated with better
performance
Robust to very rich datasets (Bender et al 2016)
Some evidence of causality
Experimental evidence (Bloom et al 2011)
Most variation within-country and within-industry
Question: Why don’t all …rms adopt the set of optimal practices?
(Gibbons-Henderson)
Hidden, unspeci…ed costs
Suboptimal decisions, but why?
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3. Manager-centric view
Popular belief that CEOs play a big role: companies thrive or ‡ounder
because of them
Charisma, vision, behavior, etc
Traditional view of role of managers:
Lucas, Gabaix-Landier (2008), Tervio (2008)
Firms bid for scarce managerial talent
Optimal allocation of managers to …rms
However:
Bertrand-Schoar (2002): FE of CEO
CEO death e¤ect
Kaplan, Klebanov, Sorensen (2012)
Bandiera, Hansen, Prat, Sadun (2016)
Question: If CEOs matter, why don’t …rms get the right one for
them?
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Managerial Heterogeneity
November 2016
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Research Question
The three views have not interacted much. Are they alternative
explanations of …rm performance? Are they orthogonal/additive
explanations?
Reconcile the three views in one theoretical framework?
Get predictions on management practices, CEO behavior, CEO
turnover, growth rates, CEO compensation, etc...
rationalize patterns observed in the three lits
generate new testable predictions
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Key Ingredients
Management quality is an asset not a ‡ow
Some CEOs are better at growing that asset, but CEO type is hidden
Boards have imperfect screening technology and monitoring skills
CEOs can take actions that boost pro…ts in the short term
Firms die when performance is too low (and are born randomly)
Lots of simplifying assumptions!
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Managerial Heterogeneity
November 2016
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Equilibrium
Bad CEOs hide their type for as long as they can by boosting
short-term performance
Management practices and …rm performance follow a stochastic
process with persistence
Steady state distribution of:
management capital
CEO behavior, CEO tenure/turnover
Firm performance
Power law
Testable predictions
Add-on: endogenize CEO wage and CEO careers
Steady state distribution of wages and CEO experience
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Managerial Heterogeneity
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CEOs
Once hired they choose one of two behaviors:
x = 1: devote their time to improving managerial practices inside the
company
x = 0: devote their time to boost short-term pro…t
E.g. monitoring operations directly vs creating an accountability
system
E.g. going on sales pitches vs incentivizing/training sales managers
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Managerial Heterogeneity
November 2016
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Firm Performance and Managerial Capital
Continuous time t
Flow pro…t/performance at t
π t = (1 + b (1
x )) Mt ,
Mt : managerial/organizational capital (including quality of the
management system, management practices, etc)
b: e¤ectiveness of the short-term boost.
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Managerial Heterogeneity
November 2016
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Managerial Capital
Dynamics
Ṁt = (θx
δ) Mt ,
δ is the depreciation rate of managerial capital
θ represents the CEO’s relative managerial skill.
Two types of CEOs: θ H > θ L
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Owner’s Objective
Maximize long-term pro…t
Z ∞
0
e
ρt
π t dt
Assume that behavior 1 is optimal for both CEO types (θ L large
enough compared to b)
If the owner observed the CEO type she would always hire the high
type and instruct him to choose x = 1
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Managerial Heterogeneity
November 2016
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Governance
Owner does not observe type of behavior directly, just performance
The owner (board) appoints the CEO and she can …re him whenever
she wants
CEOs must retire after T periods
The CEO has the option to destroy performance: the board observes
π̃ t 2 [ ∞, π t ].
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Managerial Heterogeneity
November 2016
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Naive Behavior
New CEO is hired and behaves optimally: x = 1
Managerial capital growth
Ṁt = (θ
δ ) Mt ,
(faster for θ H than for θ L )
Performance
π t = Mt ,
Performance growth rate
π̇ t
=θ
πt
δ
The low type would immediately be spotted and …red
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Managerial Heterogeneity
November 2016
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Bad CEOs Behaving Badly
Suppose the low type CEO chooses the short-term behavior
Managerial capital depreciates but he can mimick the performance of
the high CEO for a while
( θ H δ )t ;
H
πH
t = Mt = M0 e
π Lt = (1 + b ) MtL = (1 + b ) M0 e
δt .
high type
bad type
(recall bad type can destroy performance)
Mimicking becomes unsustainable after
t̄ =
Wouter Dessein, Andrea Prat (Columbia)
ln (1 + b )
θH
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CEO turnover
Bad CEOs are …red after t̄ periods
Good CEOs are kept until retirement (T > t̄)
Wouter Dessein, Andrea Prat (Columbia)
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Other Equilibria
There are other perfect Bayesian equilibria where a good CEO signals
her type by …rst playing x = 1 then playing x = 0.
(artifacts of the noise-free environment)
Two solutions:
Add noise to performance (hard)
Assume there are two types of CEOs
Those who are better at x = 1
Those who are better at x = 0
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November 2016
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CEO market: simple version
CEOs only work for one …rm (anyone who is …red is unemployable)
Wage is …xed: set it to zero
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Prop 1
Proposition
A low-type CEO chooses behavior 0, is …red after a period t̄ =
and leaves a …rm with a worse management system:
Mt̄L = M0 e
δt̄
ln (1 +b )
,
θH
< M0 .
A high-type CEO chooses behavior 1, serves until retirement, and leaves a
…rm with a better management system:
MTH = M0 e (θ
H
δ )T
.
The value of a …rm with managerial capital Mt who is about to hire a new
CEO is ĀMt , where
Ā =
1
1
ρ+δ
θH
Wouter Dessein, Andrea Prat (Columbia)
H
H
pe (ρ+δ θ )T (1 p ) e (ρ+δ θ )t̄
H
1 pe (ρ+δ θ )T (1 p ) e (ρ+δ)t̄
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A …rm with a bad CEO, a bad CEO, a good CEO, a bad
CEO: Managerial Capital
M
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
0
1 (Columbia)
2
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Prat
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4
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Heterogeneity
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A …rm with a bad CEO, a bad CEO, a good CEO, a bad
CEO: Performance
Pi
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
0
1 (Columbia)
2
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4
5
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Predictions
1
Identical …rms have di¤erent levels of managerial capital (OC)
2
Managerial capital determines performance (OC)
3
Identical …rm have CEOs with di¤erent types/behavior (MC)
4
CEO behavior determines types/performance (MC)
5
The e¤ect of CEO behavior on performance gets stronger with CEO
tenure (MC)
6
CEO behavior/type predicts accumulation of managerial capital (new)
7
CEO turnover correlates with performance and accumulation of
managerial capital (new)
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November 2016
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Equilibrium distribution of performance, etc
Horrid assumption: the e¤ect of a good CEO exactly undoes the
e¤ect of a bad CEO.
M
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0
1
2
3
4
5
6
7
8
9
10
11
t
Possible performance paths
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Managerial Heterogeneity
November 2016
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Equilibrium distribution of performance, etc
A …rm dies whenever its performance goes below a certain level π 0
With a (small) probability γ each …rm creates a spino¤ with the same
managerial quality.
Suppose …rms follow the stochastic process described in Proposition 1
What is the steady state distribution of …rms at every level?
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Managerial Heterogeneity
November 2016
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Equilibrium distribution of performance, etc
Thanks to the horrid assumption, …rms can be indexed by “waves”
that never overlap; All waves have the same weight and follow the
same path
Focus on the same wave at CEO transitions
Index possible performance levels: π 0 , π 1 , π 2 ,...; focus on even
periods.
M
1.6
1.4
o
1.2
o
1.0
o
0.8
0.6
0.4
0
Wouter Dessein, Andrea Prat (Columbia)
2
4
6
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y
2
p^2
2p(1-p)
1
(1-p)^2
0
0
Wouter Dessein, Andrea Prat (Columbia)
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Markov Chain
Let fs (k ) be the frequency of …rms with performance π k at level s
Note that if π 1 = π 0 (1 + ∆)2 , then
log π N = log π 0 + 2N log(1 + ∆)
For k
1, we have
2
fs +1 (k ) = γf s (k ) + p fs (k
1) +p (1
p )f s (k ) + (1
2
p ) fs ( k + 1 )
Also fs (0) = 0
A Kesten di¤erence equation
Related to the di¤erence equations surveyed by Gabaix (2009) but
not found in lit
Has a steady state if p <
Wouter Dessein, Andrea Prat (Columbia)
1
2
(closed form solution)
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Proposition 2
The steady state distribution of performance (at turnover time) is
given by
f ( k ) = C A Ak C B B k ,
where A and B are determined by the primitives (with B < A < 1),
and CA and CB are free constants.
Solve for the two constants by imposing:
f (0) = 0
∑k f (k ) = 1
Wouter Dessein, Andrea Prat (Columbia)
Managerial Heterogeneity
November 2016
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Wouter Dessein, Andrea Prat (Columbia)
Managerial Heterogeneity
November 2016
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Endogenous Wage and CEO Quality
So far we have assumed that CEOs only work once
What happens if a CEO can “prove herself” in one …rm and then go
to another …rm?
Which …rms will hire better CEOs
Plan:
1
2
The marginal value of CEO quality
Equilibrium with “proven CEOs”
Wouter Dessein, Andrea Prat (Columbia)
Managerial Heterogeneity
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Value Function
Forget about the equilibrium model and consider an in…nitely-lived
…rm
Expected discounted payo¤ of a …rm that is about to hire a CEO of
unknown quality:
V̄ (Mt )
Expected discounted payo¤ of a …rm that has just hired a CEO of
quality θ
Vθ (Mt )
Let p be the probability the CEO is good. We have three equations of
the form:
V̄ (Mt ) = pVg (Mt ) + (1
p ) Vg ( M t )
Vg (Mt ) = Ag Mt + Bg V̄ (Cg Mt )
Vb (Mt ) = Ab Mt + Bb V̄ (Cb Mt )
Wouter Dessein, Andrea Prat (Columbia)
Managerial Heterogeneity
November 2016
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Proposition
The value function V̄ (Mt ) is linear in Mt with coe¢ cient
1
ρ+δ
1
θH
H
H
pe (ρ+δ θ )T (1 p ) e (ρ+δ θ )t̄
H
1 pe (ρ+δ θ )T (1 p ) e (ρ+δ)t̄
The e¤ect of having a good CEO rather than a bad CEO is linear in
Mt :
Vg (Mt ) Vb (Mt ) = KMt
The amount the …rm would be willing to pay for an in…nitesimal
increase in the probability p that the CEO is good is linear in Mt
Firm with a higher managerial capital are willing to pay more for
better CEOs
Wouter Dessein, Andrea Prat (Columbia)
Managerial Heterogeneity
November 2016
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Endogenous Wage and CEO Quality
There are three types of CEOs
Those who
Those who
Those who
"standard"
have never worked, in unlimited supply
worked for t̄ and were …red (certi…ably bad)
worked for time T (which is now assumed to be the
CEO contract duration)
A good CEO turns bad with a certain probability
Wouter Dessein, Andrea Prat (Columbia)
Managerial Heterogeneity
November 2016
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Equilibrium allocation of CEO talent
The more productive …rms are willing to pay more for previously
successful CEOs
There exists a cuto¤ π̄ such that all …rms above π̄ hire previously
successful CEOs and pay a wage di¤erential w̄
All …rms below the cuto¤ hire rookies
No one hires failed CEOs
Firms at π̄ are indi¤erent between hiring a rookie or a (more
expensive) successful CEO
One can still …nd a closed-form steady state distribution of talent!
Weight is shifted to the tails.
Wouter Dessein, Andrea Prat (Columbia)
Managerial Heterogeneity
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Predictions
In a panel regression CEOs display …xed e¤ects
The career of a CEO depends on his ability to increase managerial
capital
More productive …rms are more likely to have better CEOs (reconciles
with Tervio and Gabaix-Landier)
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Conclusions
The O-view and the M-view are not alternatives; they can be
reconciled within the same model
Explains observed patterns
Suggests number of predictions on relation between
Firm performance
Management practices
CEO behavior
CEO career
CEO compensation
Add governance
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