Large Breach Penalties and Managers' Incentives to Invest Inside or Outside Firms

Managers' incentives to invest in firms' specific activities (internal investments) are compared with those to realize activities to increase their alternative market opportunities (external investments) when a managerial contract establishes a large breach penalty in the event of employment termination and wage bargaining occurs according to the outside-option principle. First, it is shown that internal and external investments are incentive substitutes from the manager's viewpoint. Furthermore, large breach penalties against firms reduce managers' incentives to invest inside (and raise those to invest outside) the incumbent employment relationship. By contrast, large breach penalties against managers perform better in enhancing managers' firm-specific investments.