A Quantitative Model of Dynamic Moral Hazard

Abstract

We develop a firm-dynamics model with moral hazard, which arises because some productivity shocks are privately observed by firm managers only. We characterize the optimal contract and its implications for firm size, growth, and managerial pay-performance sensitivity, which allow us to
quantify the severity of the moral hazard problem. Our estimation suggests that unobservable shocks are relatively modest and account for about 30% of the total variation of firm output. Nonetheless, moral-hazard induced incentive pay is quantitatively significant and accounts for 51% of managerial compensation. Eliminating moral hazard would result in about 3% increase in aggregate output.

Keywords: Structural Estimation, Dynamic Moral Hazard, CEO Compensation, General Equilibrium, Firm Dynamics

JEL Classification: G1, G3