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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 compensation packages to incentivize them. This behavior forces firms with good governance to pay their management more than they would otherwise. This externality reduces the value to firms of investing in corporate governance and produces weaker overall governance in the economy. The effect is stronger the greater the competition for managers. The need to raise external capital by firms can improve governance levels not just in the firms that are directly affected by these mechanisms, but also in the competing firms. However, poor governance can also be employed by incumbent firms as a strategic deterrent to entry by new firms. We discuss the implications of this externality view of corporate governance for regulatory standards, ownership structure of firms, and the market for corporate control.

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