Short-termism as optimal experimentation policy

Models of managerial short-termism rely on a number of assumption, such as limited availability of capital, fixed compensation schemes and an additive impact of managerial ability on revenue. We discuss the role of these assumption in generating short-termism. We show that when managerial ability ha a multiplicative impact on revenue then the first best investment policy may require the implementation of short-term projects with negative NPV in order to generate information on managerial ability that can be exploited in later periods. We also show that, when the firm is free to design the compensation scheme, the first best is attained even if only short-term contracts are allowed. Short-termism is therefore the result of an optimal experimentation policy rather than the consequence of managerial misbehavior