Corporate Governance, Favoritism and Careers

Firms may pursue non-meritocratic promotion policies, even though this undermines their performance, if entrepreneurs obtain private benefits from favoritism. Hence, better corporate governance standards favor meritocratic promotions, which in turn encourage workers' skill acquisition. The pay rise upon promotion has ambiguous effects on workers' skill acquisition: while it fosters the supply of skilled labor, it also reduces firms' incentive to promote skilled workers to managerial positions. Social welfare increases with the share of meritocratic firms, but not necessarily with governance standards: small reforms generate losers and gainers, and may on balance lower welfare, while large enough reforms generate Pareto improvements.