Moral Hazard, Investment, and Firm Dynamics

61 Pages Posted: 3 Oct 2011

See all articles by Hengjie Ai

Hengjie Ai

University of Minnesota - Twin Cities - Carlson School of Management

Rui Li

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

Multiple version iconThere are 2 versions of this paper

Date Written: August 31, 2011

Abstract

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, Moral Hazard, Investment, and Firm Dynamics (August 31, 2011). Available at SSRN: https://ssrn.com/abstract=1927373 or http://dx.doi.org/10.2139/ssrn.1927373

Hengjie Ai (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States

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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