Risking Other People's Money: Gambling, Limited Liability, and Optimal Incentives

38 Pages Posted: 12 Sep 2013

See all articles by Peter M. DeMarzo

Peter M. DeMarzo

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Dmitry Livdan

University of California, Berkeley

Alexei Tchistyi

University of Illinois at Urbana-Champaign - Department of Finance

Date Written: September 12, 2013

Abstract

We consider optimal incentive contracts when managers can, in addition to shirking or diverting funds, increase short term profits by putting the firm at risk of a low probability "disaster." To avoid such risk-taking, investors must cede additional rents to the manager. In a dynamic context, however, because managerial rents must be reduced following poor performance to prevent shirking, poorly performing managers will take on disaster risk even under an optimal contract. This risk taking can be mitigated if disaster states can be identified ex-post by paying the manager a large bonus if the firm survives. But even in this case, if performance is sufficiently weak the manager will forfeit eligibility for a bonus, and again take on disaster risk. When effort costs are convex, reductions in effort incentives is used to limit risk-taking, with a jump to high powered incentives in the gambling region. Our model can explain why suboptimal risk-taking can emerge even when investors are fully rational and managers are compensated optimally.

Suggested Citation

DeMarzo, Peter M. and Livdan, Dmitry and Tchistyi, Alexei, Risking Other People's Money: Gambling, Limited Liability, and Optimal Incentives (September 12, 2013). Available at SSRN: https://ssrn.com/abstract=2324879 or http://dx.doi.org/10.2139/ssrn.2324879

Peter M. DeMarzo (Contact Author)

Stanford Graduate School of Business ( email )

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650-736-1082 (Phone)
650-725-7979 (Fax)

HOME PAGE: http://www.stanford.edu/people/pdemarzo

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Dmitry Livdan

University of California, Berkeley ( email )

545 Student Services Building, #1900
2220 Piedmont Avenue
Berkeley, CA 94720
United States
(510) 642-4733 (Phone)

Alexei Tchistyi

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

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