Abstract: 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 give higher payoffs to their management 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 and the stronger the managerial bargaining power in setting their compensation. While regulatory standards can help raise governance towards efficient levels; market-based mechanisms such as (i) the acquisition of large equity stakes by raiders, and (ii) the need to raise external capital by firms can also improve governance levels not just in the firms that are directly affected by these mechanisms, but also in the competing firms. We characterize conditions under which such improvement is feasible and also when market mechanism may not suffice to improve governance levels.