Corporate Careers in the Shadow of Bankruptcy

*Petra Nieken
University of Bonn

Matthias Kräkel
University of Bonn

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     Last modified: January 4, 2011
     Presentation date: 03/12/2011 2:45 PM in NH 1140, Session C
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Abstract
Long-term incentives of employees are typically based on their internal and external career prospects. Using a two-person tournament model, we focus on an employee's internal career along a corporate hierarchy and analyze whether career incentives are reduced or enhanced when introducing the possibility of firm bankruptcy. Our theoretical results show that effort incentives decrease under a high risk of bankruptcy but are boosted under moderate bankruptcy risk compared to a secure career system. If bankruptcy risk is high, employees' effort choices are strategic complements leading to rather low effort in equilibrium, whereas under low risk of bankruptcy effort is high, being strategic substitutes. We tested the theoretical findings in a laboratory experiment. The results confirm the ordinal ranking of efforts under high, no, and low risk of bankruptcy. In addition, the experiment shows that under high bankruptcy risk, individuals choose efforts that are twice as high compared to the theoretically predicted levels, leading to a five times higher survival probability of the firm. We explain this puzzle by introducing a disutility of bankruptcy into the employees' theoretical objective function.