The Effect of Market Competition on Executive Pay Cap

Abstract

This paper investigates how market competition affects the adjustment of executive pay cap in Korean firms. The effect of market competition can be two-fold: Competition either increases the necessity to motivate executives by raising the maximum possible amount of compensation, which supports the role of executive pay cap as an effective compensation mechanism, or decreases the ease of executives self-serving upward adjustment of the pay cap to extract rents, which supports the role of executive pay cap as a justification tool for rent extraction. To address the research question, we employ a change regression model. The empirical findings show that an increase in market competition is associated with a decrease in executive pay cap, supporting the argument that concentrated, less competitive market structures facilitate self-serving managers rent extraction. Cross-sectional tests reveal that the negative association between market competition and executive pay cap is mitigated for firms with strong corporate governance. Additional test results show that firms that make an upward adjustment of executive pay cap under low market competition tend to increase actual executive pay, providing further support to the rent extraction story.