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Leadership t y l e n d ncentivesJulio J. Rotemberg * Garth Saloner

Sloan Schoolof Management,Massachusettsnstitute of Technology,50 MemorialDrive,E52-432, Cambridge,Massachusetts02139GraduateSchoolof Business, StanfordUniversity,Stanford,California 4305

e study the relationshipbetween a firm's environment and its optimal leadership style.We use a model in which contractsbetween the firmand managers are incomplete sothat providing incentives to subordinates is not straightforward.Leadership style, whetherbased on organizationalcultureor on the personalityof the leader, then affects the incentivecontractsthat can be offered-tosubordinates. We show that leaderswho empathize with theiremployees adopt a participatory tyle and that shareholdersgain fromappointingsuch leaderswhen the firmhas the potential for exploiting numerous innovative ideas. By contrast,whenthe environment is poor in new ideas, shareholdersbenefit from hiring a more selfish (i.e.,more profitmaximizing)leader whose style is more autocratic.(Leadership tyle;EmployeeParticipation;ncompleteContracts;ncentives or Innovation)

Studentsof businessorganizationshave long recognizedthat the heads of different companies exercise their au-thorityin differentways. Some leaders are quite auto-cratic; hey seek and receive only minimal advice fromtheir subordinates. Other leaders are more democraticand seek consensus within their organizations.Somechief executive officers issue directivesconcerning mi-nute details of operation. Others suggest only broadprinciplesand give considerableautonomyto those be-low them.Inthispaperwe providean economic model in whichleadership style has an importanteffect on firm prof-itability.We show that senior management'sstyle canalter he incentives that can be providedfor subordinatesto ferret out profitableopportunitiesfor the firm. Theresulting theory has predictionsfor the circumstanceswhere shareholders benefit from having either auto-cratic or democratic eaders.We consider a setting where the adoption of newmethods can increase firmprofitability.By adoption ofnew methods we have in mind everything from simplechanges in the configuration of production equipmentto the introduction of completely new products. All ofthese require that employees first think about ways ofchanging the firm'soperations and that, later, the em-ployees' proposalsfor change be implemented. In fact,

most large scalechanges in the firmgo througha varietyof stagesof this type fromconceptualizationo eventualadoption and implementation.What changes in busi-ness operations have in common is that they do notoccur without prior effort by the firm's employees ingeneratingviable proposals.From the firm'spoint of view the generationof pro-posals is extremelyvaluable. Proposal generation hasvalue in part because the firm learns which changeswould not be profitable and can then choose not toimplement them. This is argued forcefully by Robertsand Weitzman (1981) in the closely related setting ofsequential nvestment.There,firmsbenefit from startingmany sequential investment projectsbecause, as theyproceed, they learn whether it is worth shutting theprojectdown. The firm should even initiate some proj-ects for which the expected cost if the project s fundedto completionexceeds the correspondingexpectedrev-enue. Thereasonis that the optionto shut down projectsis valuable.One can interpretthe Robertsand Weitzman(1981)settingas one where firmspaypeopleto start nvestmentprojectsthat might lead to change. Our setting differsin that it is not possible to ensure that employees workhard at generatingviable proposals simply by payingthem for doing so. This is the appropriateassumption

0025-1909/93/3 911/1299$01$25 0SC N CE /V Ol. 39 No. 11 November 1993 1299Copyright?C1993, The Institute of ManagementSciences MANAGEMENTSCEEVO39No 1,ovme193 29

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ROTEMBERGAND SALONERLeadershiptyleand ncentives

whenever the activity of proposal generation cannotitself be structuredand monitored. The problem is thatthe outside appearanceof a proposal need not bear aclose relationshipto the amount of effort and care thatwent into developing it because it is hard to monitorand measure intellectual activity. This problem arisesnot only in the research laboratorybut also where alarge numberof employees is expectedto develop ideasfor continuous improvement.In conclusion, when thefirm wants employees to generateproposalsfor changethey confront a difficult incentive problem. We arguein this paper that the personality of the leader affectsboth the management style and the ease with whichthis incentive problemis overcome.As noted by Levinthal (1985) a simple incentivescheme that the firmcanofferemployees to inducethemto generate options for change is to rewardemployeeswhose projects are carried through to fruition. Here,however, the valuableoption that the firmhas to closeprojects down midway interfereswith its ability to pro-vide the appropriate ncentives to its managers. In par-

ticular, the existence of payments to employees eachtime one of their ideas is adopted reduces the firm'sbenefits from adopting innovations. At the same time,the knowledge that the seniormanagementmay fail toimplement their projectsreduces the incentive for thesubordinatesto generatepotentially profitableventuresin the firstplace.We investigate the effect of different managementstyles on the propertiesof this incentive scheme. Onemanagementstyle we consider is one where the seniormanagementcaresonly aboutprofits.We also considerthe possibility that decision making is sensitive to thepreferences of employees. The advantage of this latterapproachis that it is more likely to lead to the imple-mentation of the employee'sideas. As a result, t iseasierto motivateemployees to search for new methods. Ourmain finding is that in environmentswhich are rich inpotential new ideas which the firm could exploit-andwhere it is correspondingly more important to provideincentives to employees to ferretout those ideas-thelatterapproachcan actuallylead to higher profitsthansinglemindedprofitmaximization.On the other hand,the opposite tends to be true when the environmentisless rich in new ideas. In emphasizing that the mosteffective management style depends on the circum-

stances,we arefollowing the contingencyview thathascome to prevail since the workof Lawrenceand Lorsch(1967) and Perrow (1970).A managementstyle where employee wishes play arole in decision making can arise in at least two ways.First, he firmmay be able to appoint an empathic eaderwho experiences vicariously the happiness of his sub-ordinates.Second, the firmmay be able to establish aculture n which the desiresof employees aretaken intoaccount.This culturemay be established as in O'Reilly(1989) where a CEOcancreatea "socialcontrolsystem"which affects employee behavior by using the rightwords and symbols.Or,itmaybe establishedas in Kreps(1990) where managers consider their subordinates'wishes because makinga decisionthat the subordinatesdislikewould cause a loss of reputation.Our conclusionsregarding the desirabilityof taking into account em-ployee desires does not really depend on whether theleader's attributes or organizational culture are thesource of this management style. We will nonethelessdiscuss leadershipstyle as if it were due to the person-ality of the leader. We do this because the analysis ofthe effects of personality is more straightforwardandbecause it allows us to link our work to the substantialempirical iteratureon personalityand leadership style.

This literatureprovidessome supportforthe idea thatthe personality of the leader affects the organization.Graves(1986) reportsthe following example (p. 123):"A likable but indecisive leader, who coordinated butdid not interferewith the effortsof able subordinates,provided the culture of expansionism necessary for abusiness to make its markin the marketplace.He wassucceeded by one of those subordinateswho consoli-dated the position and quadrupledprofitabilityof theorganizationin six years. . rFiedler(1965) also gives great weight to the psycho-logical characteristics f the leader.He shows thatlead-erswho have a moreparticipatory tyle alsohave higheresteem for their coworkers. He regardsesteem for co-workersas a personalitytrait(which appearsrelated toempathy which we stress). He concludesthat, becausedifferent leadership styles are successful in differentsettings, firms ought to select managers using infor-mation on the managers' tendency to esteem their co-workers.While he also studies the effect of the groups'task on the ideal personalityof the leader, Fiedler em-

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phasizes that the leader's ideal type depends on thepsychological relationshipbetween the leader and hissubordinates (i.e., on whether the subordinates ike theleader).In the model we develop in this paper, we considertwo possible personalities for the leader. We call thisleader the CEO even though other people in the orga-nization, depending on the amount of power delegatedto them, may fit the model as well. As we discussed,empathic CEOs take into account the desires of theirsubordinates.By contrast,selfishCEOsmaximizeprofitsas long as they are given a small share of the profits asa personal reward. The personality of the leader alsohas other effects. In particular,empathic leaders tendto be more participatorywhile more selfish CEOs tendto be more autocratic.Becauseempathic CEOscare fortheiremployees they are more likely to elicit theirpref-erences and to allow them to do what they prefer(evenif this is costly for the firm). Given this relationshipbetween CEOpersonalityand leadershipstyle we tendto speakinterchangeablyof choosing a leadership styleand a CEO type.There exists a vast literatureclassifying leadershipstyles along a democratic-autocraticcontinuum. Thisliteratureoriginateswith Lewin and Lippitt(1938). An

example of a subsequent classificationcan be found inLikert 1967) who views organizationsas adoptingoneof four "systems,"labelled 1 through4. These systemsdiffer in a variety of characteristics.System 1 is moreautocratic n that subordinates are consulted less thansystems 2, 3, and 4. System 4 has the most subordinateparticipation.Managersareincreasinglyfriendlier andsubordinatesgrow less afraid of theirsuperiors)as onegoes from system 1 to 4. A summary of related classi-fications is provided in Bass (1981, p. 289-290).Withoutoffering as completea classification,Pascaleand Athos (1981) stress similarcontrasts.They compareHaroldS. Geneen who managedITT rom 1960 to 1979to the managementof Matsushita.Geneen emphasized"unshakeablefacts" and obtainedthese "unshakeablefacts" by promoting confrontationbetween line man-agersand those in chargeof staff functions. Geneen isfamous for his pressure-cookermeetings where man-agershad to defend theirresults n the face of aggressivequestioning by Geneen and other managers.To someextent, these meetings provided subordinateswith the

ability to express their opinions. However, the un-shakeable facts were often used to remove employeeswhose performancewas less than completely satisfac-tory.

The management style at Matsushitawas much moreparticipatory.Decision making there involved seekingconsensus and not unilateral decision making by theCEO. The company also spent considerablymore re-sources developing and trainingits employees. As wediscuss later,this latter tendency may also be related tothe participatory tyle.Our paper is closely related to the work based onCoase (1937) which arguesthat firms arise as a partialsolution to the intrinsic ncompletenessof contractsbe-tween parties.'Firmsare seen as creatingrights of con-trol, and those who are given these rights make thosedecisions that cannot be contractuallystipulated. Thissolution is generally only partialin that control struc-tures are typicallynot sufficient to obtain the outcomethat is possible with complete contracts.A better out-come would be possible if the universe of availablecontractswere expanded.For this reasonfirmsdo betterwhen, as is proposed by Shleifer and Summers(1990),they hire "fair-minded" CEOs who can be trusted tofollow throughon implicitpromises. Shleiferand Sum-mers'( 1990) proposalis similarto ours in that personalcharacteristicsof the CEO matter because contractsare incomplete. The main difference is that "fair-mindedness" is a desirable characteristic or all CEOswhereas we focus on personal characteristics hat areappropriate in some contexts and inappropriate inothers.

Our paper proceeds as follows. In the next sectionwe presentourbasic model. In the interest of obtaininga simple characterizationof the benefits of differentCEO-types,we make several simplifying assumptionsin this section that we later relax. Section 2 analyzesthis simplemodel and compares he outcomeunder twoextremetypes of CEO,one who caresonly aboutprofitswhereas the other cares only about the welfare of hissubordinates.Section3 formulatesand solves the prob-lem of maximizingthe fit between CEOpersonalityandthe environment of the enterprise. Section 4 extends

1See Holmstromand Tirole(1989) for a survey.

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the model to show that CEOswho caremore about thewelfare of theirsubordinatesare also moreparticipatory.Up to this point we emphasize that effort is requiredto generate new ideas and that one key managerialproblem is to reward this effort. To develop this ideawe assume the firm and its potential employees aresymmetricallyinformed about their ability. This is re-laxed in ?5 where we considerthe case where the em-ployees have superior information about their ability.We show that the main result, that an empathic CEOcan be profitablewhen the environment is rich in po-tential ideas, survives in this setting. In that section weshow also that autocracyand empathy have differentimplications regardingself-selection of employees. De-

pending 'on the setting, empathic or autocraticCEOswill find it easier to induceonly the mostable employeesto join theirfirms. Section 6 presentsour conclusions.

1. The ModelThe situation we examine is one in which a managercan expend effort developing an idea which, if suc-cessfullyimplemented,mightimprovefirmprofitability.This effortmight entail the searchfor an improvementin eitherproductdesign or deliveryto the finalcustomer,the investigation of a method to reduce costs, or thedevelopment of a new product.Firmsobviously differin theirpotential forundertakingsuchprofit-enhancingventures so that only some managersare in a positionto pursuethem. Forexample,in matureindustries withstable marketsand established technologies such op-portunitiesare likely to be rarerthan in emerging in-dustries.We have in mind product enhancements that gothrough two stages. In the first,the managerinvests agreat deal of personal time and effort inresearching heprofit-enhancing dea and developing a proposalfor itsimplementation.The second stage consists of the im-plementation itself, which may be carried out by themanager or by others. Importantly,however, the finaldecision as to whether or not to implement the projectis in the hands of a more seniormanagerwhom we callthe CEO.The fruitsof the manager'sefforts are assumed to bestochastic. That is, the potential profitto be reaped by

the firm f it eventually implements a manager'sprojectis uncertain at the time that the manager must decidewhether or not to put his effort into the project.Whilesome projects will look better than others, the exactprofitabilityof the venture is unknown until the projecthas been researchedby the manager.1.1. Notation and TimingIt is useful to think of events as unfolding over threeperiods. Managerialeffort to develop the idea takesplace in the firstperiod. In the second period, the ideais implemented. Implementationusually requiresthatthe firmspend additional resourceson the project.Fi-nally, in the thirdperiod,the implementedprojectbearsfruit. The random variable G denotes the profitof animplemented projectfrom the second period on.Ignoringdiscounting,G equals the increasedrevenue(or reduced cost) in the third period minus the imple-mentation costs incurredin period two. We let the re-alization G of the random variable Ghave a cumulativedistributionfunction F(G) and correspondingdensityfunctionf (G). It is importantto stress that the realiza-tions of Gcan be negative. A negative G simply meansthat the costs of implementingthe idea exceed the ben-efits. The less "rich"the environment in terms of theprofitopportunities t presents,the higherthe likelihoodthat G is negative, i.e., the greater s F(O).

Good projectsonly become availableif the managerdevotes effort. We initiallymake two assumptionsthatsimplify the exposition. First,we assume that all man-agers are equally capable of uncoveringvaluable proj-ects.Werelaxthisassumption n ?5. Second, we assumethat managerswho make an effortalways have someprojectthatthe CEOmightimplementwhile those whodo not make an effort have no project that could beimplemented. It would probably be more realistic toassume insteadthat some managerswho makeno effortcan present a project for the CEO to implement andthat, on the other hand, some of the managerswho domake an effort are actually unable to put together aprojectthat would appearviable. We consider the firstpossibilityin ?3 and the second in ?5. For the momentwe assume that a projectwith payoff Gbecomes avail-ableif and only if the managerdevoteseffort to it duringthe firstperiod. If he does so, the variable we denote e

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equals1 and,otherwise, t equals 0. If e = 1, the potentialgain from the project G becomes known to both themanagerand the CEO at the end of the firstperiod.2The CEO must then decide whether or not to imple-ment the projectduringthe second period. We denotethe implementationdecision by I: I = 1 if a projectisimplemented and I = 0 if it is not. Finally, at the endof the second period,the profitfromany projectwhichis researchedand implemented is earned by the firm.1.2. Preferences and ProfitsWe assume that the manager'sutility depends only onhis effort e and on his income. Webreak down the man-ager's compensation into the wage, w, for a managerwho does not have the opportunity of undertaking aprofit-enhancingproject and who thus performs onlyhis "usual"tasks,and the "incentive"paymentkwhichis tied to the effort e. As we discuss more fully below,we do not let kdepend on the actualeffort made. It willdepend instead on whether the CEO actually imple-ments the project o which the employee devoted effort.Depending on the project, ts implementationcouldalsoaffect the manager's utility function directly. For in-stance,some individualslike to travel and so would liketo be in chargeof implementing internationalprojects.Also, the improvement in the manager'sprospects inthe external labormarketfollowing implementationofhis projectcould generatesome directutilityof this sort.For the moment we consider projects whose imple-mentationdoes not give the managerany directutility.The extension to those that do is brought up in ?4.32 It is not important for our analysis whether the actual value of Cbecomes known at the end of the first period or whether the CEOand managersimply have a more accurate estimate of what G willbe. For simplicity we assume G becomes known, but the results canbe derived by having manager and CEO obtain an estimate, say Ge,of what G will be.3 In structure,the model is thus similar to Hart and Moore (1988)who consider the relationship between a buyer and a seller. In theirmodel both of these can make an effort to raise the value of theirfuturetransactionwith each other. This effort is noncontractible.Allthat can be contracted on is the price at which the good will be de-livered. If the seller has the option of not buying at this prespecifiedprice, he is in a position analogous to our CEO who mustpay a pricek for implementationbut can choose not to implement the projectatall.

As is typical in principal-agentmodels, we supposethat thereis some minimum level of w below which themanagerwill refuse to work. Thisminimum level of wfor performing "normal" tasks can be thought of asbeing determined in a competitive market for mana-gerial talent.We assume that the manager'sutility is linear in k(sothat he is risk-neutralover income in excess of w) andthat exertingthe effort e gives him disutility d.4 Sincewe areinterestedin the change in the manager'sutilityfrom undertaking projects,we normalize his utility sothat his utility when he receives w is zero. Then themanager'sexpectedutility as a function of k and e cansimply be written as u(k, e) = E(k) - ed where E(k) isthe expectationof k.The focus of our analysisis the utility function of theCEO. In a traditionalmicroeconomic model in whichthe CEO maximizes profits, the CEO would seek tomaximizeI(G - k). Thisassumptioncan be justifiedbythinking of the CEO as selfish and having a contractthat gives him a (possibly trivial) fraction of the firm'sprofits.Herewe consider not only selfishCEOsbut alsoCEOswho are concernedabout the well-being of theirsubordinates.CEOswhose utilitydepends on the utilityof theirmanagerwill be termedempathic.Formally,wesuppose that at the time he makes his implementationdecision,the CEOplacesweight 0 on profitsandweight1 - 0 on the manager'sutility. Thus the CEOseeks tomaximize:

I[(1 - 0)(G - k) +Ok]. (1)Note that any effortthat might have been expended

by the manager priorto the implementationdecisionis4 Lettingthe manager'sutility be linear in income beyond w impliesa form of risk aversionsince the worker does not accepta wage beloww. This form of risk aversion is not, per se central to our analysis.What is central is that the employee remain an employee and notbecome the owner of the enterprise.In other words, we cannot letthe employee become the residual claimant on all the firm's cashflows. It might be thought that a risk neutral employee would bewillingto become the owner. However, this becomes impossibleonceit is recognizedthat a companyhas many interdependentemployeesand that they cannot each become the residual claimantof the entirefirm. If, for instance, there are n employees and each is given oneshare in the firm then each gets only 1/ n of the profitsthat he gen-eratesso that he will not act as the residual claimant.

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"1water nder the bridge" and therefore the disutilityof that effort doesn't enter the CEO's preferences.The variable 0 is the key variable in our analysis. Itcan be thoughtof as representing he "personality ype"of the CEO. A CEO whose 0 = 0 is a selfish profit-maximizer:he caresonly about the "bottom line" andnot at all about the utility of the manager who worksfor him. As 0 rises, the CEO becomes more empathicso that his concern for profitdeclinesvis-a-vis his con-cern for his manager's welfare. In the extreme casewhere 0 = 1 he cares only aboutthe welfare of his man-ager.Given the motivation for the paperwe offered in theintroduction, we would like to equate selfish CEOs(those whose 0 = 0) with an autocratic eadership styleand empathic ones with a more participatoryone. In?4 we explain why such labels might be appropriate.Forthe moment it should suffice to say that those CEOswhose 0 is positive care about the manager'swelfare.One would thus expect them to ask the managerhowhis utility can be increased and trust the manager totake desirable actions. (Even actions that increase themanager'sutilityat the expenseof the firm'sprofitsmaybe desirable to an empathic CEO.) This tendency ofempathic CEOs to give resources to their employeesmay well be costly to the shareholders.5We denote theincrease n costs from having an empathic CEO overwhat they would be underprofit-maximizationby C(0)(so that C(0) 0).'Inthe "background"arethe firm'sshareholderswhohave the authorityto hire the CEO.Since they are re-moved from the day-to-day operations of the firm,they are assumed to be solely interested in profit-maximization and to be unconcerned about the man-ager's utility as long as he is compensated sufficientlyto induce him to do his job. Thus the CEOis the inter-mediarybetween two sets of stakeholders,the manager5 A countervailingbenefit exists when manager and CEO do not ob-serve the actual value of G in the second period. Then, a CEO whomaximizesprofitswill tend to spend too much in finding out the truevalue of G. He may, for example, have to appoint separate "taskforce" to performthis function.6 Littlehinges on thisassumption,and indeed the opposite assumption(that the participatorymanager is more efficient) simply involvesreinterpretingC(0) as a cost saving, rather than a cost increase.

and the shareholders,and his preferences play a rolein determiningthe sharingof the profitsbetween them.1.3. Informational Assumptions and

ContractibilityAn importantdistinction n our model is whether or notthe CEO is able to base the manager's compensationdirectly on the manager's effort. Consistent with thecontracting iterature7 we term the case where the CEOcan do so, the "complete contracts" case. One simpleconditionthatmakescomplete contractspossibleis thate be verifiable."Verifiability"means not only that the relevant in-formation s observableby the CEO,but also that it canbe established by the body responsible for enforcingthe compensation agreement between manager andCEO. In an extreme case this enforcementbody mightbe the Courts, in which case verifiabilityrefers to theabilityto establish the facts beforea judgeorjury.Moreoften, however, the enforcement is performedby otheremployees. If the CEO is observedto have reneged onan implicit agreement with the manager (for exampleby withholding payment of a "bonus" when it is un-derstood by the employees that the circumstanceswar-rant a bonus being paid) this has deleterious effects onhis reputation for "fairdealing." In this context, veri-fiability refers to the manager's ability to convince theother employees in the firm that he did indeed carryout the requiredeffort.Typically e is not verifiable because it is difficult todistinguish cases in which the manager s really puttingin the necessary effort and when he is simply goingthroughthe motions. Indeed, in the agency literature tis typicallyassumed that the effortcannotbe preciselyobservedby anyone other than the managerhimself.The lack of observabilityof e does not, by itself, pre-vent a completecontractfrombeing writtenin our set-ting. A complete contract will still be possible as longas G is verifiable. Since the manager is assumed to berisk-neutral,he is indifferentbetween receivinga directpayment d for exerting effort and receiving a largerpayment (which depends on G) when G turns out tobe positive, i.e., only in those cases where he in fact'See Holmstrom and Tirole (1989).

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comes up with a profitable proposal. Formally, themanager is indifferent between receiving d always andreceiving a payment qG where k d/ E(G). This isbecause the expected value of kG at the beginning ofthe firstperiod is simply E(qG) = E(kG E(G)) = d. Onaverage, G is a perfect indicator of whether or not themanager exerted the effort and therefore he is as happyto have his compensation based indirectly on the out-come of his effort as directly on the effort itself.In practice, however, even G is likely to be very dif-ficult to verify. Accounting profit figures are subject tomanipulation through the allocation of overhead andother cost items. This manipulation is extremely costlyto detect. Moreover, this form of manipulation is noteasy to reduce by making partial audits and imposingbig fines on firms found to have manipulated theirbooks. The reason is that many of these manipulationsare conceivably justified so that it is hard to decide,even expost, the correctprocedure for determining costs.In any event the principal force that ensures thatmanagers receive their incentive payments is probablyreputational. When a particularmanager has been suc-cessful, this becomes known to those that work withhim. These also learn whether that employee is treated"unfairly." If the firm treats its employee unfairly, thispeer group lets others know. This loss of reputation, inturn, makes it harder for the firm to attract new em-ployees. Making payments to the employee depend onG is not possible if other employees do not readily ob-serve G. It is for this reason that we ignore such con-tracts.What peers can easily observe is whether the man-ager's project is implemented. They can determine thisbecause, through their contact with the manager, theyknow the basic content of the project so the firm is un-able to implement the project and pretend that it ob-tained the idea elsewhere. Thus contracts that make thepayment to the manager depend on whether his ideasare implemented are relatively easy to enforce. No out-side enforcement party is even needed. Because of thiswe focus on these contracts.These contracts differ in one fundamental respectfrom contracts studied in the traditionalprincipal-agentliterature.8In that literature, as in our model, contracts8 See, for instance, Holmstrom (1979).

depend on a variable which is imperfectly related toeffort. The difference is that, in the traditional literature,the variable is manipulable only by the agent who ismaking the effort. Here, the variable also depends onthe decision of the principal who is paying the agentwhich is why the personality of the CEO plays such acrucial role.

Since the only action on which the manager's com-pensation can be made contingent is whether or not theproject is implemented, a contract in this incompletecontracts setting consists only of the promise of somepayment k if the project is implemented.9

Given this contract, managers ought to be keen onhaving their projects implemented. While empirical ev-idence on this is sparse, some support comes from thestudy by Ritti (1968). He asks engineers and scientistsworking in the private sector about their goals and as-pirations. Among the engineers, 67% say that it is veryimportant to work on problems that have practical ap-plications important to their company, and 69% saythat it is very important to have the opportunity to helptheir company increase its profits. Among research sci-entists, only 28% deem the latter very important. Bycontrast, 88% of the scientists view publication in tech-nical journals as very important.10

Ritti (1968) views these differences as mattersof basicpersonality. A different interpretation, and one that isconsistent with our model, is that because engineerswork on applied problems it is possible to provide themwith compensation schemes that depend on the finalimplementation of their projects. Accordingly, engineersdo in fact care that their work has valuable practicalimplications to their company. By contrast, scientistsinvolved in basic research cannot be compensated forthe implementation of their ideas. Accordingly, giventhe incentives they face, they tend to be more concernedwith outside recognition than with enhancing the prof-itability of their firms.9 If the idea is not implemented, the manager simply earns his res-ervation wage w. Paying the employee more would be wasteful. Pay-ing him less is impossible given our specification of employee tastes.Our results would still go through if there was no minimum paymentbut the k has to be thought of as the difference between the paymentif the project is implemented and the payments if it is not.10See also Badawy (1971).

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The contract that specifies the contingent payment kis entered into between the CEO and the manager. Asdiscussed above, the "contract" may be implicit ratherthan explicit,relying on enforcement through reputationrather than litigation. In either case, however, it is sub-ject to the oversight of the shareholders. While theshareholders cannot be expected to monitor the detailedoperations of the firm (such as which projects shouldbe implemented and which should not), they can beexpected to monitor the broad structure and level ofthe compensation packages that the managers are of-fered.11In our model this is captured by assuming thatwhen the contract is specified at the beginning of thefirst period, the shareholders can object if k is set "toohigh." Formally, we shall assume that, as profit-maximizers, the shareholders insist that kis set no higherthan is absolutely necessary in order to elicit effort.

2. Analysis2.1. The Complete ContractsCaseThe case in which the CEO is a profit-maximizer andfaces no contracting or informational difficulties pro-vides a useful benchmark for the more interesting casesthat follow. In this case the CEO would be able to inducethe manager to research those projectswhich he wishedresearched simply by offering the manager a paymentof d (the manager's disutility of effort) to undertake thetask.The CEO would therefore instruct the manager toresearch certainprojects.He would then implement anyproject for which G > 0. Therefore, the expected netgain from researching a project is:

00GdF(G) d. (2)

Note that expression (2) exceeds E(G) - d preciselybecause the CEO has the option of not implementingprojects whose Gis less than zero. Therefore, there existprojects for which E(G) - dis negative which are worth" Monitoring by outsiders, be they shareholders via the Board of Di-rectors or other creditors, is undoubtedly imperfect, and our analysistakes into account some of these imperfections.

investigating.12 Starting projects gives the CEO the op-tion of shutting them down, and this option is itselfvaluable. What our paper demonstrates is that this op-tion is not as worthwhile once contracts areincomplete.With complete contracts any project for which (2) ispositive is researched and is implemented whenever itsrealization of G is positive. As discussed above, this

outcome can be implemented even if e is not contractibleas long as the value of G at the end of the first period(before implementation) is contractible. In particular,we argued that the manager would make the requisiteeffort if his payment equals dG/E(G). However, thiswould induce the manager to exert effort in all projects,including those for which (2) is negative. Thus, the CEOwould also have to tell the manager for which projectshe will give him this incentive payment.Another among many schemes for implementingthe complete contract involves paying the managerd/(1 - F(O)) whenever G ? 0. Then the average pay-ment to the manager equals d, and the manager is will-ing to make the requisite effort.2.2. The Incomplete Contracts CaseThe difficulty that arises when complete contracts areimpossible to enter into can be seen by contemplatingthe use of a contract analogous to the second one dis-cussed above. In that scheme, the manager is effectivelypaid only when the project is implemented. Supposethat the contract continues to ensure that the manageris paid d/ (1 - F(0)) when the project is implementedbut that it is not possible to ensure that all projects withG ? 0 are implemented.At the implementation stage (period 2), the CEOexpects the firm to earn additional profits of G - d/(1 - F( O)) if the project is implemented. If the projectis not implemented the CEO expects the firm to earnno additional profits, but since the payment of d/(1 - F(O)) is contingent on implementation, he alsoneed not compensate the manager for his additionaleffort. Thus a profit-maximizing CEO implementsprojects only if G ? d/(l - F(O)). Therefore, in con-trast to the complete contracts case, the CEO doesnot implement those projects for which 0 < G12 This is precisely the point of Robertsand Weitzman ( 1981 ) referredto in the introduction.

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< dl/l(- F(O)). Some projects which would be prof-itable were it not for the increased compensation to themanager that their implementation would imply, arenot implemented. This inefficiency was also noted byLevinthal (1985).13The net result is that if the manager exerts effort heis paid d/(l - F(O)) with probability smaller than(1 - F(O)). His expected compensation from exertingeffort therefore falls short of d with the result that hewill choose not to exert the effort, and the project, whichon average is profitable, will not be undertaken.

Of course the optimal contract in the complete con-tracts case is not the optimal contract when contractsmust be incomplete. We therefore now examine the op-timal contracts in an incomplete contracts setting andcontrast the outcomes when there is autocratic andwhen there is participatory top management.2.3. Selfish Top ManagementWith incomplete contracting the CEO can only offer acontract which specifies a payment k which dependson whether the project is implemented. With such acontract in place, the selfish CEO would choose to im-plement any project for which G > k. The probabilitythat a project that a manager researches will eventuallybe implemented is therefore 1 - F(k). Knowing this,the manager would be willing to exert effort only if

k[l - F(k)] 2 d, (3)i.e., if his expected increase in utility outweighs the costof effort.

The lowest cost contract which induces the managerto put in the effort is therefore that with the lowestvalue of k which satisfies Equation (3). Since both theshareholders and the CEO want to maximize profits inthe autocratic case, they are in agreement that the CEOshould choose a payment just large enough that themanager's increase in expected utility from exerting ef-fort is exactly equal to his disutility of doing so. Thispayment by the autocratic CEO to the manager whichwe denote k' is defined implicitly by

k'[l - F(k')] = d. (4)13 He views this inefficiency as due to double sided moral hazardbecause the CEO's failure to implement the project in some instancesin which G > 0 can be thought of resulting from the CEO's moralhazard.

Notice that k"must be at least as large as d since F(kV)? 0. In the special case where F(d) = 0, i.e., where theincreased profitability of every project exceeds d, thenk' is equal to d. In that case if the manager is paid d ifthe project is implemented he is certain that every proj-ect that he researches will in fact be implemented. Hencehe is happy to receive a payment of d contingent onimplementation.

If F(d) > 0, however, so that there exist some projectswhich ex post will turn out not to have been worth themanager's effort, then k' will exceed d. That is, theprofit-maximizing CEO must pay the manager morethan his disutility of effort when his project is imple-mented in order to induce him to research the projectin the firstplace. The reason for this is that the managerrealizes that he will only be paid some of the time evenif he puts in the effort. In particular, if 0 < G ' katheCEO will choose not to implement the project. Thusthe manager insists that he be paid more when he ispaid.

This can lead to a difficulty. As the project becomesimplemented less often, the manager requires a higherpayment when the project is implemented. But, thishigher payment leads the CEO to implement the projectless often. There might thus exist no payment for whichthe projectis ever implemented; Equation (4) might nothave a solution.A necessary condition for (4) to have a solution isthat increases in k raise the left-hand side of (4). Theydo so only if F changes relatively slowly as G changes.In particular, the left-hand side of (4) rises with k onlyif the elasticityof F with respect to its argument is smallerthan one. If it is bigger, it is impossible to induce theemployee to make the necessary effort when manage-ment is autocratic.

Assuming a solution to (4) exists, and given that theCEO implements any project for which G > k", theautocratic CEO's firm's expected profits with this opti-mal contract are given by:

(G - ka)dF(G)= GdF(G) - ka[l -F(kaka ka={ GdF(G)-d. (5)

Ta

The second term in ( 5) reflects the fact that on average

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the manager is paid d. The first term simply representsthe average profitabilityof the projectand is the averagevalue of G for a project that is implemented ex post,i.e., the average value of G given that G 2 ka. This termis decreasing in k', i.e., the higher k' is, the lower arethe expected profits from undertaking the project in thefirst place. This is because as k' rises it becomes lesslikely that the CEO will ultimately implement the proj-ect, even when it turns out that G > 0.

Comparing (2) and (5), the expected payment to themanager is d both in the complete contracts case andthis incomplete contracts autocratic CEO case. However,the increase in expected profits to the firmis lower withincomplete contracts by

ka GdF(G). (6)This is because the firmloses those profit opportunitieswhere 0 c G c ka.These lost profit opportunities can sometimes be suf-ficient to eliminate altogetherthe benefits from exploringthe project. The solution to (4), assuming it exists, willoften involve a high value of k'. This occurs in particularwhen [1 - F(d)] is small, i.e., if a relatively small fractionof the projects are worth doing. However, it is apparentfrom (5) that if k' gets "too large" it may not be worth-while to have the manager exert the effort in the firstplace: the firm may not be able to exploit its possibleprofitable opportunities at all. This can occur even if itwould be worthwhile to undertake the project withcomplete contracts.2.4. Empathic ManagementTo keep the presentation simple we now turn to theother extreme, the CEO whose 0 equals one so that hecares only about the manager's utility. Given the in-complete contract, such a CEO implements any projectwhich is recommended to him. The contingent paymentk in this empathic (and participatory) case is denotedkV. The manager undertakes the project providedkP> d.The shareholders would choose a level of compen-sation for the manager that is just sufficient to eliciteffort. Thus they would insist that the CEO set kP = deven though the CEO would like to pay the managermore. We assume that they succeed in enforcing this

though this assumption is not restrictive since any ad-ditional payments the CEO makes to the manager arecaptured by C(1). Since the project is undertaken re-gardless of its merits, shareholders' profits are

E(G) - d - C(1). (7)This participatory style has two disadvantages vis-a-

vis profit-maximization with complete contracts. First,C( 1), if positive, contributes negatively to profits. Sec-ond, this CEO implements projects even if they are notworthwhile (G < 0). Thus, ignoring C( 1), the net ben-efits from the project equal E(G) - d. As discussedabove, this is the value of the project when the CEOgives up his option to shut down unprofitable projects.2.5. Selfishness and Empathy ComparedIn this subsection we show that even the extreme CEOwho cares only about the manager can obtain higherprofits than those that follow from period-by-periodprofitmaximization. We do this by comparing the firm'sprofits when 0 = 0 and when 0 = 1. The difference inexpected profits is

,A [E(G) - d - C(1)] - GdF(G) drka

- GdF(G) - C(1). (8)The sign of A is ambiguous in general. The inefficiency

of participation, represented by C( 1), weighs the scalesin favor of autocracy. Apart from this effect, the relativeprofitabilityof the two regimes is ambiguous: it dependson the sign of the first term in (8) which may be positiveor negative. That is, even if the selfish CEO is moreefficient at carrying out the operations of the firm, hisfirm may nonetheless be less profitable than that of anon-profit-maximizing participatory CEO

The intuition for this result is the following. As longas the manager stands to gain if the CEO implementshis project, the CEO whose 0 = 1 will implement it. Asa result, the manager can easily be induced to undertakehis project, and the net result is that every project isresearched and implemented. While this means thatsome unprofitable projects are implemented, it alsomeans that all of the profitable ones are, too.The profit-maximizing CEO is unable to achieve thisoutcome. Both he and the manager understand that as

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facilitates the generation of new ideas. Insofar as theautocratic style does not reap as many of the benefitsfrom new ideas, shareholders of firms whose CEOs areautocratic do not benefit from this type of training.

3. The Best CEO for the JobThus far we have contrasted the extreme selfish andempathic management styles and have discussedthe circumstances under which each style is the pre-ferred one. The main result so far is that profit-maximizing shareholders may choose to hire a non-profit-maximizing CEO. In this section we go one stepfurther and suppose that the shareholders can chooseamong candidate CEOs with different personalities asmeasured by their concern for their workers. That is,we suppose that the shareholders can choose a CEOwhose personal "6" is best suited to the environmentin which the firm operates. In order to do this we ex-amine how shareholder profitability varies with 0.A secondary objective of this section is to show thatour basic results extend to the more realistic case wheremanagers can generate proposals even without exertingeffort. Lackof effort results instead in proposals of lowquality. In particular, these proposals would, if imple-mented, lead to net revenues equal to G < 0. The resultof this modification is that CEOs with 0 = 1 becomeundesirable because they implement the manager'sproject even in the absence of any effort. Thus, suchextremely empathic CEOs do not lead the manager toexpend any effort. Nonetheless, the basic insight of theprevious section that some degree of empathy can im-prove incentives remains valid in this case.We suppose that the CEO is of type 0 and that themanager is offered a contract which pays him k0if hisprojectis implemented. In that case, in the second periodthe CEO will choose to implement a project that themanager has researched if

(1 - 0)(G - k0)+ Ok0 0,that is, if

G ' (1 0)ko. (10)If G satisfies (10), then the manager will surely makeno effort since he receives k' in any event. We thus

assume for the moment that G does not satisfy (10).We show below that this is indeed true for the optimalCEO. As a result, the manager exerts effort (sets e = 1)during the first period if his expected future incentivepayments exceed his disutility of effort. That is, if

k0dF(G)2?d((1-20)/(1- O))k di.e., if

[1- F()1- 20k1k? d (11)The shareholders would like the manager to be paid

no more than is absolutely essential in order to inducehim to work. They would thus like ( 11) to hold as anequality. We once again assume that they succeed inenforcing these incentive payments and that any com-pensation the manager receives over and above whatthey desire is captured by C(0). The resulting k0,whichwe denote kO*,s that for which

[1- F(110 ko*)k* = d. (12)The firm's expected profits are then given by:

(G - ko*)dF(G) - C(O), (13)which, using (12), can be written as:

GdF(G) - [1 - F(ko*)]ko* C(O)

= GdF(G)-d-C(0). (14)((1-20)/(1-0))k'*

Notice first that, assuming the manager makes an ef-fort, the cases we considered in the previous section areindeed special cases of this more general formulation.If 0 = 0, kV* k from Equation (12) (since ((1 - 20)/(1 - 0)) = 1 in this case). But then the expression forexpected profits in Equation (14) is identical to that inEquation (5). Similarly, the extreme empathic case isapproached as the limit as 0 -* 1. Then, ((1 - 20)/1 - 0)) -o - coso that the expression for expected profitsin Equation (14) reduces to that given in Equation (7).Two terms in Equation (14) depend on 0:the integraland C(0). Consider the integral first. The integral



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Figure 2 The OptimalValue of 6

I I fGdF(G)I(1-e )ke

0 B' 2 1 82

reaches a maximum when the lower limit of the integralis zero. If the lower limit is any lower, negative-profitprojects are included; if the lower limit is any higher,positive-profit projects are excluded. How the integralvaries as 0 varies, therefore, depends on how the lowerlimit varies with 0. In fact it is straightforward to showthat the lower limit is strictly decreasing in 0 and thatit is equal to zero when 0 = 1/2.14 The value of theintegral as a function of 0 is therefore as represented inFigure 2. C(0), which is increasing in 0, is also depictedthere.If there is no difference in efficiency across regimes,that is if C(0) is the same for all 0, then profits are max-imized if 0 = 1/2: The "best" CEO is one who caresequally about profits and his manager's utility. The in-tuition for this is that at the implementation stage aCEO with 0 = 1/2 cares as much about the benefit thatthe manager obtains from his additional compensationas he cares about the effect of that compensation on theprofitability of the firm. Overall, therefore, he does not14 To see this notice that

d 1 - 28\ -1de 1 - a } 1 - 0) 2 ?

so that (( 1 - 20) / (1 - 6)) is a decreasing function of 6which is equalto 1 when 6 = 0, is positive when kV* 1/ 2, and negative thereafter.The term kV*s positive, and from ( 12), is decreasing in 0. Thereforethe lower limit, which is the product of ((1 - 26)/(1 - 0)) and kV*is strictly decreasing in 6 and is zero when 6 = 1/2.

care about the manager's compensation but, instead,worries only about whether G > 0: i.e., whether or notthe profits of the firmwill increase as a result of imple-menting the project.

Thus the CEO's ex post incentives are optimal: heimplements exactly those projects which should be im-plemented from a profit-maximizing point of view. Themanager's compensation is then set so that he is willingto exert the effort necessary to research the project eventhough the project will only be implemented if it turnsout to be profitable. The overall outcome is identical tothat which would be achieved if the firm were able towrite a complete contract with the manager. Note that,as a consequence of the fact that only projects whoseG exceed zero are implemented, (10) is violated for G,and managers who exert no effort do not receive anyincentive payments.One can also see from Figure 2 that if C(0) is increas-ing in 0, the optimal 0 for the firm, 0*, is strictly lessthan 1/2. Thus the firm should lean in the direction ofautocracy (from 0 = 1/ 2) when the participatory styleis less efficient in conducting the day-to-day operations.This strengthens the conclusion that, for the optimal 0,the manager is not paid if he does not exert any effort.The extent to which a firm should reduce the 0 of itsCEO depends on the distribution function F. It is forthis reason that different firms must in general haveCEOs with different personalities. In particular,for thesame C(0), firmsfor which the integral in Figure 2 risesrapidly because they have access to many valuableprojects should end up with a higher 0* than firmswithout access to such projects (whose integral is flat).The management style, and hence the 0 that firmschoose obviously affects the range of projects that thefirm should seek to explore. In other words it affectsthat range of projects for which (14) is positive. Theinvestment rules derived by Roberts and Weitzman(1981) apply only in the case of complete contracts,and they have to be suitably modified, depending onthe management style of the firm.

4. Empathy and ParticipationSo far we have simply asserted that more empathicCEOs also have more participatorymanagement styles.In this section we show this is true in the sense that aMANAGEMENT SCIENCE/VOl. 39, No. 11, November 1993 1311


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more empathic CEO will ask his manager questionsabout a broader range of issues than a more selfish one.Also, a more empathic CEO is more likely to delegatedecision making to his manager. To obtain this result,we require that there exists a larger menu of courses ofaction available to the CEO. Thus we assume that afterspending effort, the manager produces two alternativeprojects, which we label 1 and 2. These are alternativesin the sense that only one can be implemented profit-ably. The net revenue from implementing only project1 is G1while that from implementing project 2 is G2.Both of these values are drawn independently from thesame distribution function F.The mere existence of a wider menu need not affectdifferentially the communications of selfish and em-pathic CEOs with their managers. Such differences doarise if, as we now assume, the manager's utility de-pends on the project that is implemented. We assumeimplementation of project i gives the manager utilityequivalent to zi units of income and that the realizationsz1 and Z2are independent draws from a distributionfunction H (and density function h) whose mean isi? 0.15

As before, the outcome of the manager-CEO inter-action depends on what is contractible. Given that wenow have a choice of projects, it depends in particularon whether contracts can specify payments which de-pend on the zi of the implemented project. Fora varietyof reasons this seems implausible so that we continueto assume that payment can only depend on whethera project is implemented at all.16 Then, assuming he15 This mean would be strictly positive if the manager's prospects inthe external labor market improve following implementation of hisidea.16 It should be clear that such payments would tend to arise if contractswere complete. To see this, note that overall efficiency demands thatthe project be implemented whose Gi + zi is highest. One simplescheme that would achieve this under full information is having themanager pay the CEO zi in exchange for implementation of projecti. From the CEO's perspective, profits are then equal to Gi + zi. Oneproblem with this scheme is that the manager knows zi better thanthe CEO and is unlikely to volunteer the information if he must alsopay zi in exchange for having project i implemented.A different problem arises even when the CEO knows zi as well.The existence of this type of payments then open the door to moreexploitative treatmentof the manager. If the CEOis always at freedomto demand payment from the manager to improve the job he may

implements any project at all, the CEO implement theone which maximizes (1 - 6)Gi + 6zi. For the purelyselfish CEO whose 0 is zero this is equivalent to justmaximizing net revenues G. Thus such a CEO hasnothing to gain by learning which project the managerprefers. He will act autocratically. By contrast, a moreempathic CEO's implementation decision depends onthe manager's preferences so that he will elicit them.

One weakness of this formal model is that this elic-itation of the manager's preferences is the same for anyCEO whose 0 is even slightly above zero. So the degreeof participation is discontinuous in 0. However, thisweakness can probably be remedied in a more elaboratemodel where learning about the manager's preferencestakes time. Then such learning becomes more worth-while for the CEO the more his own utility depends onmaking a decision that the manager likes. Thus this sortof learning would tend to rise continuously with 0. Notealso that, for 0 sufficiently high, the CEO will simplylet the manager pick which project gets implementedsince the difference in their G's will be of little relevancerelative to the difference in their z's.We have now shown that CEOs with higher 0 areindeed more participatory in that they are more likelyto ask their employees which project they would liketo see implemented. The question is then whether tend-ing to implement the project which the manager likesbest is bad for the shareholders. To answer this question,we will neglect the issues discussed in the previous sec-tion and assume that the CEO always implements oneof the two projects. This would follow from assumingthat, given that the manager makes an effort, the small-est G in the support of F is larger than d. Then, eventhe completely selfish CEO is willing to pay d to imple-ment one project, and this payment is sufficient to in-duce the manager to make an effort.

A CEO of type 0 chooses to implement project 1 ifG, - G2 ? k(Z2- zl) where k equals 0/(1 - 0). So weintroduce the indicator function I such that

also be at freedom to demand payment in exchange for not makingthe job worse. If this were possible, the manager might never be paidmore than the minimum wage w needed to keep him from leaving.The reason is that the CEOcould always extractany incentive paymentsuch as k by threatening to make the job less pleasant.

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I(G1, G2, Z1, Z2)1, if G, - G2 2 O(Z2 - Zl)I(G1, G2, Zl, Z2) { , otherwise.

(15)Given a payment to the manager k0whenever a proj-ect is implemented and ignoring C(0), expected profitsare then equal to

~ h f[10G, (1 I 2Z2 Z1 G2 G1[IG+lIX dF(Gl)dF(G2)dH(z1)DH(z2)- k0. (16)

After receiving his subsistence wage w, the manager'sexpected utility when his CEO is of type 0 isk0+ I f [Iz1 + (1 - IO)z2]Z2 Z1 G2 G1

X dF(Gl)dF(G2)dH(z1)DH(z2) - d. (17)From the shareholders' point of view, the ideal koisthe one that makes the expression in ( 17) equal to zero.Assuming once again that shareholders succeed in in-ducing the CEO to give this incentive payment, (16)becomes

~J1 fG f, [1o(G1+ z1) + (1 - Io)(G2+ Z2)]Z2 Z1 G2 G1X dF(Gl)dF(G2)dH(z1)DH(z2). (18)

For 0 equal to zero, the autocratic case, Io picks theproject whose G is highest. To see the advantages ofempathy, it is useful to compare this case with that inwhich 0 = 0.5. As we showed in the previous section,this is the optimal 0 when C(0) can be neglected. In thiscase X equals one so that the CEO picks the projectwhose Gi + zi is highest as efficiency demands. Nowconsider any realization of {Gi, Gj, zi, z;}. If Gi 2 Gand Gi + zi 2 Gj+zj, then, since both types pick projecti, the contribution to (18) is the same. If, instead,Gi 2 Gjbut Gi + zi < Gj + zj, then I(O) picks projecti while I(1/2) picks project j so that Io(Gi + zi)+ (1 - IO)(Gj + zj) is smaller than I112(Gi + zi)+ ( 1-1/2) (Gj+ zj). Therefore, overall expected profitsare higher when 0= 2We have thus shown that shareholders benefit from

an empathic CEO's choice of projects (at least if his 0equals 0.5). This may be surprising since, ex post sucha CEO tends to choose the projects that the managerlikes even when this project does not maximize profits.However, insofar as this allows the contract with themanager to have correspondingly lower wages (as oc-curs when (17) is zero), the shareholders benefit.

The issue is then whether, in practice, it is possiblefor shareholders to ensure that CEOs whose 0 is higherpay lower incentive payments. If they are completelyunable to do this, so that k0 is the same for all 0,profits are highest with the most autocratic manager.Such a manager ensures that, for each realization of{ G1, G2, Z1, Z2 }, IG, + (1 - I) G2 s as high as possibleso that (16) is maximized. In practice, shareholdersprobably are neither able to completely determine knortotally unable to have any influence. Then, a 0 some-what smaller than 0.5 will be appropriate.In conclusion, this section has shown that, if themanager cares about which project is implemented,there is an additional reason to hire an empathic CEO.Such a CEO will tend to implement the project that themanager likes, and this participatory behavior raisesprofits if wages are adjusted accordingly.

5. Managers of Varying AbilitiesTo keep the presentation straightforward we have as-sumed that all managers have the same ex ante abilityto generate valuable projects. The analysis also appliesdirectlyto certain cases where managerialability differs.One key issue, as stressed for instance, by Amit et al.(1990) is whether the difference in ability betweenmanagers is common knowledge. There is commonknowledge when the manager's own perception of hisability matches the CEO's and both are aware of thiscommonality of opinion. Thus, there trivially existscommon knowledge about ability when managers donot have any particular information about their ownability that is not based on their publicly known recordof accomplishment. We would then expect the marketwage w of managers of different abilities to differ aswell. Whether it differs or not, the analysis in the pre-vious sections applies directly;it determines the optimalarrangements for each particular type of manager,where a type of manager is defined by his or her F. For

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each type of manager there would be a different k whichwould itself depend on the management style of thefirm.

We will now deal with the case where the CEO andthe manager are differentially informed about the man-ager'sability. This complicates the analysis in two ways.First, the payment k provides different incentives foreffort to managers who see themselves as having dif-ferent abilities. Thus, the choice of a payment k affectswhich sorts of managers will exercise effort. Second, ifthe k is chosen so that managers of differing abilitiesmake an effort, then their expected total payments willdiffer. This affects the attractiveness of the firm to dif-ferent potential employees; it can induce "self-selection"of relatively able or unable managers.We show that, as before, empathic CEOs have a par-ticular advantage in generating effort when the resultingideas are likely to have small positive payoffs. The mainnovelty in this section's analysis is that empathic CEOsfind it relatively costless to generate effort by the rela-tively less able managers. In particular,unlike the caseof autocracy, inducing these to make an effort does notrequire that more able managers be given a large rent.Thus empathic CEOs are particularly desirable whenthe effort of people without unusually great talent isvaluable to the firm. Matters are different when onlythe effort of the particularlyable employees is profitable.Then, the firm may gain by having the opportunity togive large rents to more able employees without creatingan incentive for less able individuals to exert effort. Thereason this can be beneficial is that these rents make iteasier to recruitrelatively capable employees. When thisis an importantconsideration,autocraticCEOsmay thushave an edge.

Suppose that there are two different types of -man-agers. Type h has high ability. By exerting an effort thatcosts him d, he develops a project with probability Ph.The payoff of a project developed by a high abilitymanager has a c.d.f. given by H(G). In the current no-tation, the model of the previous sections had ph equalto 1. The reason we want to consider the case whereeffort does not automatically lead to a project is thatthis seems realistic. There are cases where it is commonknowledge that the effort has been in vain. One could,of course, think of these as situations where G is low.What distinguishes these outcomes from those that

simply have low G is that failure to generate a projectis common knowledge whereas G is known only by themanager and the CEO. As we shall see below, this dis-tinction matters and this realistic modification makesparticipatory management more attractive.There also exist lower ability managers whose typewe denote by 1. By exerting effort which also costs himd, such a manager develops a potentially viable projectwith probability P1. The payoff of a project developedby a low ability manager has a c.d.f. given by L(G).Because type I managers have lower ability, PI< Ph andL(G) ? H(G) for all G.An additional complication in the case of asymmetricinformation about types is that the reservation wagesof the two types might be different. For simplicity ofexposition, we first ignore this possibility so that basewages w and required average wages are the same forboth types. We consider the case with differential re-quired wages below because it affects the relative easewith which employees of the two types can be recruited.

With complete contracts and perfect information, thebenefit to the firmfrom paying d to the type h managerto make an effort is

,GdH(G) - d (19)while the analogous expression for the type I manageris

fGdL(G)-d. (20)With incomplete contracts, the CEO's only method

for providing incentives is, again, the payment k whichis conditional on implementation. With a purely selfishCEO, the high ability manager will make an effort onlyif this payment satisfies (3) which here is given bykPh[1 - H(k)] > d. (21)

If there exist k's that satisfy this inequality, the small-est of these is the most profitable one, assuming theCEO wants only the high ability manager to make aneffort. Denote that k by k'. The resulting profits fromthe effort by the high ability manager are then equal to

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where the equality follows from the definitionof k'. Toobtain effort from the low ability manager as well, re-quires that k satisfy

kPI[1 L(k)] ? d. (23)Because PIis lower than Ph and L k) is larger thanH(k), the left-hand side of (23) is larger than that of(21) for any value of k. Therefore, f k'sexist thatsatisfy(23), they are larger than khand they automaticallysatisfy (21). Let the minimum k that satisfies (23) begiven by k'. This is the kthat maximized profits assum-ing the CEO induces both types to make an effort.As-sumingthere areNhmanagersof type handN,managersof type 1, the resulting profitsare given by

NhPh (G-ka)dH(G) +NAIP, (GNhPh (C- k)dH(G) + NP1 (G - k )dL(G)

= NhPh GdH(G) + NiPI GdL(G)- (Nh+ NI)d ph[l - L(k1)] WlJNhd 24)

where the equality follows from the definition of ki.The CEO essentially has a choice between setting kso that only the high ability manager makes an effortand setting it at a level that induces both types to exerteffort.He prefers the formerif Nh times the expressionin (22) is larger than (24). Then, profits are maximizedby setting k equal to kh, otherwise they are maximizedby setting it equal to k .We see that the selfish CEO does not extractas muchbenefit from eithertype of manageras would be possiblewith complete contracts.In both cases, projects whoseG is relatively low are ignored. This problem is moresevereif the low abilitymanager s also induced to makean effort because, in this case, the cutoff k is higher.When the lower abilitymanager is induced to make aneffort,the higher ability managerearns a surplusaboved for makingan effort.The existence of such a surplus,which equals the expressionin braces in (24), is stan-dardin adverse selection models.Considernow the empathicCEOwhose 0 equals one.The choice of k must now be made directly by the

shareholderssince such a CEOpresumablyalways pre-fers a higher k. For any positive k, the empathic CEOwill implement any viable projectobtainedby any em-ployee. If Ph or PI is lower than one, managers whomake an effort do not always receive the payment k.The reason is that with some probabilitythey do notdevelop a viable project. Even if the empathic CEOwishes to pay k to these unlucky employees, he cannot.Assumingthese probabilitiesareless than one thus rec-ognizes that shareholdersexercise some leeway even ifthe CEO is very empathic. For a projectto be imple-mented requiresthat it have some minimum level ofplausibility and managers, particularlylower abilitymanagers,cannot be sure that their ideas will pass thistest.If their CEO is empathic high ability managerswillmake an effort if

Phk?d. (25)The lower abilitymanagerwill make an effortif

Plk2 d. (26)Since Ph 2 PI, the minimum k that induces type 1tomake an effort, which we denote by kpis no smallerthan kP, the minimum k that leads type h to the makean effort. In the special case where Ph = Pi, these twok's are identical.Profits when only type h managers make an effortare given by

NhPh GdH(G) Nhd C(1) (27)whereas when kis such thatboth make an effortprofitsequalNhPh GdH(G) +NIP, GdL(G)

-oo -oo- 2d - C(1)-Nh{(Ph/PI - 1)d}. (28)

The expressionin braces is, once again, the rent ex-tractedby each type h manager.We are now in a po-sition to compare the two extreme types of CEO. Wesee first that, if Ph is equal to PI, the purely empathicCEOhas a disadvantagein that he cannot induce onlyone type of manager to exert an effort. It is importantto note, however that this is a weakness only of the

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CEOwhose 0 is exactly one. Even slightlysmallervaluesof 0 generally imply that there are some realizations ofG for which the CEO does not implement the project.As a result, the high ability manager receives the pay-ment kmore frequentlyeven when both types make aneffort. It is then possible to set k so that only the highability managermakes an effort.

Suppose that, indeed, k is set that so that only typeh makes an effortwith eithermanagementstyle. Then,the difference in profits is the difference between theexpressionin (27) and Nh times the expressionin (22).It equals

NhPh GdH(G) C(1) - Ph GdH(G)k h= Nh GdH(G) - C(1) (29)-OC)

which is ambiguous in precisely the same way as (8),the expressionwhen there was only one type of man-ager.We now consider the case where the autocraticandthe empathic CEOset k so that both types of managermake an effort. The difference between the profitsearned with autocracyand those earned with partici-patory managementis now the differencebetween (28)and (24)Nh GdH(G) - N,J GdL(G)- C(1)

_ fPh[l - H(ki) Ph1 N.(0t Pll-L ka) ] p}dNh ( 30)1[1 L(ki) PI

The first three terms in this expression areanalogousto those in (8). Inducing the effort of the low abilitytype requiresa higher k so that the benefits from thehigh ability ype'seffort are ower under autocracywhilethey remain unchanged under participation.Whetherthe autocraticCEO or the empathic one benefits morefrom the effortof the type 1manager s againambiguous.If the type 1managerproduces relativelymany projectswith negative G's then the autocraticmanageris betterin this regardwhile if many of his projectshave positivebut small G's the empathic one is better. The term inbraces is positive so that it makes the empathic stylemore desirable. It captures the differencein the rents

garnered by the type h managersunder the two man-agement regimes.The rents arehigherunder autocracybecause the autocraticCEO makes the payment k rel-atively more often to the type h manager. Thus,for anygiven k, there is a biggerdifferencebetween the earningsof the two types under autocracythan under partici-pation. This means that, when the k's are adjusted sotype 1managersreceived, type hmanagersreceivemoreunder autocracy.In the currentmodel these rents representa cost tohaving a selfish CEO. The reason is that, because therequiredwages are the same for the two types, the firmhas no difficulty in attracting type h managers. Largerents for type h employees can, however, be a benefitto the firm f it is necessaryto pay type hmanagersmorein order to attractthem to the firm.We thus consider now a situation where the reser-vation wages of the two typesdiffer.Typel's reservationwage when he makes zero effort remains equal to wwhile type h's is now w + z. We let the cost of effortremain equal to d for both types. Thustype h managerswould only join the firmand expect to make an effortif their expected payments equal at least w + d + z.Since the firmdoes not know the individual's type, itsonly mechanism for giving type h managersthe extraincome z is to increasek.The consequence of such an increasein kis that type1managersbecome more likely to make an effort.Thisis not, per se, bad for the selfish CEO since he onlyimplements projectson which his firmgains profits. Itis potentially bad forthe empathic CEO,however. Sup-pose in particular, hat the effort of type 1managersisunprofitableon average if his projectsare always im-plemented so that PIf GdL G) < d. Then, the fact thatan increase in k makes the type 1 manager make aneffort has a deleterious consequence on the empathicCEO'sprofits.One is tempted to conclude from this analysis thatthe selfish CEOfinds it easier to recruittop talent. Theintuition for such a result would be that relativelyin-effective managersdo not thrive under such a bottom-line oriented CEO. This intuition is only partly right,however, because the selfish CEO sometimes finds itdifficultto take advantage of good managers. Supposein particular hat, because of the form of the distributionfunctionH, there exists no kwhich satisfies(21 ). Then,



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the selfish CEOcannot inducea type h manager o makean effortby paying him d for it, let alone give him theextraz that he requires.By contrast,a k of (d + z)/Phis sufficient to attract such a managerto a firmrun byan empathic CEO.Moreover, f Ph is sufficientlyhigherthanPI,this k is not sufficientto induce the type 1man-agerto make an effort.Thus, thereeven exist situationswhere the empathic CEO finds it easier to recruittal-ented managers.On the other hand, in situationswhere type h man-agers produce projectswhose G is very high (so thatthey arevery able) while type 1managersproduceproj-ects whose G is very low, the autocraticCEO has anedge in attractingtype h managers.He can set k quitehigh without fear of eliminatingthe effort of his typeh manager or of reducing his profits from the type 1managers.By contrast he empathicmanagerwould losefrom his type 1managersif his firmraisedk.In this case, where the adverse selection problem isvery severe because the types are very different wewould expect autocratic and participatory irms to usevery different recruitmentmethods. Autocratic firmswould need to do only a cursoryexaminationof theirjob candidatesbecause the less able would not cost thefirm very much. By contrast, shareholders in partici-patory firms would have to take greater precautionsagainst hiring relatively inept managers;their recruit-ment processwould have to be more selective.6. ConclusionsWe have presenteda model where shareholdersselectthe firm'sleadershipstyle to maximize ex ante profits.Leadershipstyle affects the corporatecultureof the or-ganization in that employee's beliefs about how theywill be treatedin various circumstancesdepend on it.Inthe model, maximizationof exanteprofits sometimesrequires that the firmnot be too keen on maximizingex post profits.Leadershipstyle mattersbecause it canachieve this aim.The principalopen question left by this research isits empirical relevance. To what extent does the dis-tinctionbetween participatory nd autocratic tyleshelpus understandthe effectivenessof research nside firms?To what extent are these differences n leadershipstyleopportunisticfacades that any managercan adopt, and

to what extent do they hinge instead on the CEO'sin-herent personality traits?Fiedler (1965) shows that the extent to which theleader gives a favorabledescriptionof his least preferred

coworker is positively correlatedwith the permissive-ness and human-relations orientation of the leader. Healso shows that leaders who give such favorable de-scriptions tend to be more successful in decision andpolicy makingteams and in groupsthat have a creativetask. These activities certainly seem to involve more re-search of the type that we have considered than thegroups in which the more autocratic eaders performedwell. These latter groups include basketball and sur-veying teams, open hearth shops and military combatcrews. One question that is left open by Fiedler's re-search is whether the regard one has for one's leastfavored coworker is a feature of one's personality orwhether it is molded by the work environment.

Miller et al. (1982) and Millerand Toulouse (1986)study more directly he extent to which CEOpersonalityaffects both strategy (i.e., whether the firms are inno-vative) and structure(i.e., whether the firms are auto-cratic). Millerand Toulouse( 1985) consider three per-sonality traits.The first is locus of control. Individualswith internallocus of controlfeel that what happens tothem is the resultof theirown actions,while those withmore external locus of control tend to view their envi-ronment as having a largerrole in shaping their life.Miller and Toulousereportthat firmswhose executiveshave an internal locus of control tend to innovate moreand also tend to delegate more. The relationshipbe-tween locus of control and innovation is statisticallyvery significantwhile that between locus of controlanddelegation is significant only at the 10%level.Another personality attributethey consider is flexi-bility.Those who areflexibleareadventurousand adapteasily, those who are not tend to be more rigid. Ac-cording to their study, CEOs whose personalitiesaremore flexible tend to lead firms that innovate and del-egate more, though only the latter relationshipis sta-tistically significant. The finding that there exist per-sonality traitswhich lead to both more innovation andmoredelegationseemsbroadly consistent with our the-ory if one views most innovations as being the resultof research whose payoff tends to lie in the "middle"region [0, ka].

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ROTEMBERGAND SALONERLeadership tyleand Incentives

Finally, Miller and Toulouse (1986) consider needfor achievement (nAch) of various executives. Individ-uals with high nAch set relatively difficult goals forthemselves and try to achieve them with little outsidehelp. Miller and Toulouse show that executives with ahigh need for achievementtend to lead innovative firmsthat delegate little. This seems inconsistent with ourstory that innovative firms delegate. However, closerinspection of their results show that this correlation strueonly for small firms. Thus they seem to be pickingup the existence of individual innovators whose needfor achievement is high and, in partas a result,succeedin creating viable companies. This is not inconsistentwith our theory if these innovations are made by theCEO himself. Our theory implies that delegation helpssubordinates (not the CEO) to be innovative.One of the reasons the results of Miller et al. (1982)and Miller and Toulouse (1986) are only partial s thatthey focus on differentpsychological traits than thosethat emerge naturally from our theory. In our theory,what is importantis the extent to which a CEO caresfor the welfare of his employees. This might well bemeasurableby some index of empathy like the one pro-posed by Mehrabian and Epstein (1972). Mehrabianand Epstein(1972) reportthat subjectswhose index ofempathywas high were also willing to spend more timehelping others. This suggests that it is quite possiblethat CEOsmeasuringhigh on this index might want totreat theiremployees well. Thus one implication of ourtheoryis that firmsthat do relativelywell in innovativesectors ought to have CEOs with a high index of em-pathy, holding everything else constant."717We wish to thank Tom Allen, RichardBurton,Dan Levinthal,andthe referees forcomments,as well as the National Science Foundationand the InternationalFinancialServices ResearchCenter at M.I.T. orsupport.ReferencesAmit,Raphael,LawrenceGlosten, and Eitan Muller,"Entrepreneurial

Ability, Venture Investments, and Risk Sharing," ManagementSci., 36 (October 1990), 1232-1245.

Badawy,M. K.,"Industrial cientistsand Engineers:MotivationalStyleDifferences,"CaliforniaManagementReview (Fall 1971), 11-16.

Bass,Bernard,Stodgill'sHandbook f Leadership, he Free Press,NewYork, 1981.

Buss, Arnold H. and Stephen E. Finn, "Classificationof PersonalityTraits,"J. Personality nd SocialPsychology,52 (1987), 432-444.

Coase, Ronald, "The Nature of The Firm,"Economica November1937), 386-405.

Fiedler,Fred E., "Engineer he Jobto Fit the Manager,"HarvardBusi-nessReview,43 (Sept.-Oct. 1965), 115-122.Graves, Desmond, CorporateCulture-DiagnosisandChange,St Mar-

tin's Press, New York, 1986.Hart,Oliver and John Moore, "IncompleteContractsand Renegotia-

tion," Econometrica, 6 (July 1988), 755-786.Holmstr6m, Bengt, "MoralHazard and Observability,"BellJ. Eco-

nomics Spring 1979), 74-91.andJeanTirole,"TheTheoryof the Firm" n RichardSchmalenseeand RobertWillig (Eds.), Handbookof IndustrialOrganization,North Holland, Amsterdam,1989.

Kreps, David, "CorporateCulture and EconomicTheory,"in J. Alteand K. Shepsle (Eds.), RationalPerspectiveson Positive PoliticalEconomy,CambridgeUniversityPress, Cambridge,1990, 90-143.Lawrence,Paul R. and JayW. Lorsch, Organization ndEnvironment,Harvard Business School Press, Boston, MA, 1967.

Levinthal,DanielA., ThreeEssayson EconomicModelsof Organizations,Stanford Graduate School of Business Ph.D. Thesis, 1985.

Lewin, K. and R. Lippitt,"An ExperimentalApproachto the Studyof Autocracyand Democracy:A PreliminaryNote," Sociometry(1938), 292-300.

Likert,Rensis,HumanOrganization,McGraw-Hill,New York,1967.Mehrabian,Albert and Norman Epstein, "A Measureof Emotional

Empathy," J. Personality,40 (1972), 525-543.Miller, Danny, Manf

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