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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)

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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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, Financial Markets Group dp347, Financial Markets Group.
  2. Oded Galor & Joseph Zeira, 2013. "Income Distribution and Macroeconomics," Working Papers, Brown University, Department of Economics 2013-12, Brown University, Department of Economics.
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  5. Brishti Guha, 2005. "Honesty and Intermediation: Corporate Cheating, Auditor Involvement and the Implications for Development," Working Papers, Singapore Management University, School of Economics 18-2005, Singapore Management University, School of Economics.
  6. Joh, Sung Wook, 2003. "Corporate governance and firm profitability: evidence from Korea before the economic crisis," Journal of Financial Economics, Elsevier, Elsevier, vol. 68(2), pages 287-322, May.
  7. Banerjee, Abhijit V & Newman, Andrew F, 1993. "Occupational Choice and the Process of Development," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 101(2), pages 274-98, April.
  8. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 52(4), pages 647-63, October.
  9. Holmstrom, Bengt & Tirole, Jean, 1993. "Market Liquidity and Performance Monitoring," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 101(4), pages 678-709, August.
  10. Tirole, J., 1993. "A Theory of Collective Reputations with Applications to the Persistence of Corruption and to Firm Quality," Working papers, Massachusetts Institute of Technology (MIT), Department of Economics 93-13, Massachusetts Institute of Technology (MIT), Department of Economics.
  11. Greif, Avner, 1993. "Contract Enforceability and Economic Institutions in Early Trade: the Maghribi Traders' Coalition," American Economic Review, American Economic Association, American Economic Association, vol. 83(3), pages 525-48, June.
  12. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, American Economic Association, vol. 79(1), pages 14-31, March.
  13. Shapiro, Carl & Stiglitz, Joseph E, 1984. "Equilibrium Unemployment as a Worker Discipline Device," American Economic Review, American Economic Association, American Economic Association, vol. 74(3), pages 433-44, June.
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