Moral Hazard, Investment, and Firm Dynamics

61 Pages Posted: 3 Oct 2011

See all articles by Hengjie Ai

Hengjie Ai

University of Wisconsin-Madison

Rui Li

University of Wisconsin - Madison; Purdue University - Department of Economics

Multiple version iconThere are 2 versions of this paper

Date Written: August 31, 2011


We present a dynamic general equilibrium model with heterogeneous firms. Owners of the firms delegate investment decisions to managers, whose consumption and investment are private information. We solve the optimal incentive compatible contracts and characterize the implied firm dynamics. Optimal risk sharing requires managers' equity share decrease with the 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.

Keywords: Dynamic Mechnism Design, General Equilibrium, Investment, Payout Policy, Power law

JEL Classification: C73, D51, D82, D92, E13, E22, G35.

Suggested Citation

Ai, Hengjie and Li, Rui and Li, Rui, Moral Hazard, Investment, and Firm Dynamics (August 31, 2011). Available at SSRN: or

Hengjie Ai (Contact Author)

University of Wisconsin-Madison ( email )

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Madison, WI 53706
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Rui Li

Purdue University - Department of Economics ( email )

West Lafayette, IN 47907-1310
United States

University of Wisconsin - Madison ( email )

716 Langdon Street
Madison, WI 53706-1481
United States

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