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A Theory of Firm Decline

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  • Gian Luca Clementi

    (New York University and RCEA)

  • Thomas Cooley

    (New York University and NBER)

  • Sonia Di Giannatal

    (Centro de Investigación y Docencia Económicas)

Abstract

We study the problem of an investor that buys an equity stake in an entrepreneurial venture, under the assumption that the former cannot monitor the latter’s operations. The dynamics implied by the optimal incentive scheme is rich and quite different from that induced by other models of repeated moral hazard. In particular, our framework generates a rationale for firm decline. As young firms accumulate capital, the claims of both investor (outside equity) and entrepreneur (inside equity) increase. At some juncture, however, even as the latter keeps on growing, invested capital and firm value start declining and so does the value of outside equity. The reason is that incentive provision is costlier the wealthier the entrepreneur (the greater is inside equity). In turn, this leads to a decline in the constrained–efficient level of effort and therefore to a drop in the return to investment.

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Bibliographic Info

Paper provided by Fondazione Eni Enrico Mattei in its series Working Papers with number 2010.88.

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Date of creation: Jun 2010
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Handle: RePEc:fem:femwpa:2010.88

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Keywords: Principal Agent; Moral Hazard; Hidden Action; Incentives; Survival; Firm Dynamics;

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  1. Espino, Emilio, 2004. "On Ramsey's Conjecture: Efficient Allocations in the Neoclassical Growth Model with Private Information," Economics Series 154, Institute for Advanced Studies.
  2. Peter M. Demarzo & Michael J. Fishman & Zhiguo He & Neng Wang, 2012. "Dynamic Agency and the q Theory of Investment," Journal of Finance, American Finance Association, vol. 67(6), pages 2295-2340, December.
  3. Bohacek Radim, 2005. "Capital Accumulation in Private Information Economies," The B.E. Journal of Macroeconomics, De Gruyter, vol. 5(1), pages 1-24, December.
  4. Khan, A. & Ravikumar, B., 1997. "Growth and Risk-Sharing with Private Information," Working Papers 97-13, University of Iowa, Department of Economics.
  5. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  6. Sandro Brusco & Eva Ropero, 2007. "Financing Constraints and Firm Dynamics with Durable Capital," Department of Economics Working Papers 07-08, Stony Brook University, Department of Economics.
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Cited by:
  1. Antonio Mele, 2008. "Repeated Moral Hazard and Recursive Lagrangeans," 2008 Meeting Papers 482, Society for Economic Dynamics.
  2. Josepa Miquel-Florensa, 2013. "Dynamic contractual incentives in the face of a Samaritans’s dilemma," Theory and Decision, Springer, vol. 74(1), pages 151-166, January.
  3. Emilio Espino, 2012. "Investment and Insurance in an Economic Union," 2012 Meeting Papers 1176, Society for Economic Dynamics.
  4. Loderer, Claudio & Waelchli, Urs, 2010. "Firm age and performance," MPRA Paper 26450, University Library of Munich, Germany.
  5. Tsyrennikov, Viktor, 2013. "Capital flows under moral hazard," Journal of Monetary Economics, Elsevier, vol. 60(1), pages 92-108.
  6. Hengjie Ai & Rui Li, 2012. "Moral hazard, investment, and firm dynamics," CQER Working Paper 2012-01, Federal Reserve Bank of Atlanta.

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