Zenan Wu and Xi Weng
We consider a two‐period model in which the success of the firm depends on the effort of a first‐period manager (the incumbent) as well as the effort and ability of a second‐period manager. At the end of the first period, the board receives a noisy signal of the incumbent manager’s ability and decides whether to retain or replace the incumbent manager. We show that severance pay can be utilized in the optimal contract to provide a credible commitment to a lenient second‐period equilibrium replacement policy, mitigating the first‐period moral hazard problem. Unlike existing models that aim to rationalize managerial entrenchment, we identify conditions on the information structure under which both entrenchment and anti‐entrenchment emerge in the optimal contract. Specifically, our model predicts that it is optimal for the board to design a contract to induce entrenchment (respectively, anti‐entrenchment) if the signal regarding the incumbent manager’s ability becomes sufficiently uninformative (respectively, informative).