Corporate Governance Externalities*

When firms compete in the managerial labor market, the choice of corporate governance by a firm affects, and is affected by, the choice of governance by other firms. Firms with weaker governance offer managers more generous incentive compensation, which induces firms with good governance to also overpay their management. Due to this externality, overall level of governance in the economy can be inefficiently low. Poor governance can in fact be employed by incumbent firms to deter entry by new firms. Such corporate governance externalities have important implications for regulatory standards, ownership structure of firms, and the market for corporate control.