Moral Hazard, Investment, and Firm Dynamics

Abstract:     
We present a dynamic general equilibrium model with heterogeneous firms. Owners of firms delegate investment decisions to managers, whose consumption and investment decisions are private information. We solve the optimal contracts and characterize the implied firm dynamics. Risk sharing requires that managers' equity share decrease with firm size. This in turn implies that it is harder to prevent private benefit in larger firms, where managers have lower equity stake under the optimal contract. Consequently, smaller firms invest more, pay less dividends, and grow faster. Quantitatively, we show that our model is consistent with the Pareto-like size distribution of firms in the data, as well as the pattern of the relationships between firm size and firms' investment and dividend policies.

Number of Pages in PDF File: 54

Keywords: Moral Hazard, Dynamic Contracting, General Equilibrium, Firm Dynamics

JEL Classification: E13, G30

working papers series