Moral Hazard, Investment, and Firm Dynamics

54 Pages Posted: 12 Mar 2012 Last revised: 6 Aug 2014

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: January 11, 2012


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.

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

JEL Classification: E13, G30

Suggested Citation

Ai, Hengjie and Li, Rui and Li, Rui, Moral Hazard, Investment, and Firm Dynamics (January 11, 2012). AFA 2013 San Diego Meetings Paper, Available at SSRN: or

Hengjie Ai (Contact Author)

University of Wisconsin-Madison ( email )

975 University Avenue
Madison, WI 53706
United States
6088903881 (Phone)


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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