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The Case of the Errant Executive : Management, Control and Firm Size in Corporate Cheating

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  • Brishti Guha

    (SMU)

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    Abstract

    Firm insiders a manager and a board face moral hazard in relation to their outside shareholders in a repeated game with asymmetric information and stochastic market outcomes. The manager determines whether or not outsiders are cheated; the board, whose objectives differ from those of outside shareholders, attempts to control the manager through compensation contracts and dismissal threats Since compensation determines the managers incentive to cheat, firms competing for outside capital publicly announce their managerial contracts. However, secret renegotiation between firm and manager is still possible : so outsiders guard against being cheated by limiting their total stake in any firm. This imposes a credibility constraint on firm size, providing a rationale for the shape of long-run cost curves. Given this limit on outside funds, the minimum size requirement for enterprises to become operational and the ability to pay managers enough to ensure honesty both set a floor to the personal wealth required to enter entrepreneurship. Thus, we endogenize entry into industry, establish a unique equilibrium for any distribution of wealth, and characterize different equilibria. We also explain features of poor countries like dominance of family firms, moral hazard induced vicious circles that retard industrialization and the stimulus that inequality may provide to industrial development.

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    Bibliographic Info

    Paper provided by East Asian Bureau of Economic Research in its series Microeconomics Working Papers with number 22428.

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    Date of creation: Jan 2005
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    Handle: RePEc:eab:microe:22428

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    Related research

    Keywords: moral hazard; firm size; managerial compensation; repeated games;

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    1. Denis Gromb, 2000. "Public Trading and Private Incentives," FMG Discussion Papers dp347, Financial Markets Group.
    2. Lal, Deepak & Myint, H., 1998. "The Political Economy of Poverty, Equity and Growth: A Comparative Study," OUP Catalogue, Oxford University Press, number 9780198294320.
    3. Greif, Avner, 1993. "Contract Enforceability and Economic Institutions in Early Trade: the Maghribi Traders' Coalition," American Economic Review, American Economic Association, vol. 83(3), pages 525-48, June.
    4. Abhijit V. Banerjee & Andrew F. Newman, 1990. "Occupational Choice and the Process of Development," Discussion Papers 911, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    5. Galor, Oded & Zeira, Joseph, 1993. "Income Distribution and Macroeconomics," Review of Economic Studies, Wiley Blackwell, vol. 60(1), pages 35-52, January.
    6. Brishti Guha, 2005. "Honesty and Intermediation : Corporate Cheating, Auditor Involvement and the Implications for Development," Microeconomics Working Papers 22426, East Asian Bureau of Economic Research.
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