A Model of Optimal Corporate Bailouts
41 Pages Posted: 5 May 2011 Last revised: 5 May 2012
Date Written: May 10, 2011
We analyze incentive-efficient government bailouts within a canonical model of intra-firm moral hazard. Bailouts exacerbate the moral hazard of firms and managers in two ways. First, they make them less averse to failing. Second, the taxes to fund bailouts dampen their incentives. Nevertheless, if third-party externalities from keeping the firm alive are strong, bailouts can improve welfare. Our model suggests that governments should use bailouts sparingly, where social externalities are large and subsidies small; eliminate incumbent owners and managers to improve a priori incentives; and finance bailouts through redistributive taxes on productive firms instead of forcing recipients to repay in the future.
Keywords: Government Bailout, Moral Hazard, GM, Chrysler, TARP
JEL Classification: P16, P14, D72
Suggested Citation: Suggested Citation