Moral Hazard, Investment, and Firm Dynamics

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.