The Moral Hazard of Managers' Decisions: Theory of the Firm with Limited Liability

A model is set up i which firms borrow their entire working capital from banks. A firm which is characterized by a smooth and convex cost function chooses its production level, borrows the amount necessary to finance the associated production costs, and then sells its output in the subsequent period at a random price. In case the revenue is not sufficient to cover the loan, including interest payments, the firm defaults and receives zero profits. Otherwise, the firm receives the revenue minus the loan and interest payments. With such a limited liability rule, the loan works as an insurance against bad outcomes (low price realizations), and it is shown that the managers of a firm then may choose higher production levels than they otherwise would have, letting the bank bear the risk. Iyt is shown that this limited liability rule can induce the the firm to react in an unusual manner, compared to the standard theory of the firm. It is possible that there are adverse incentive effects, as a firm might react to an increase in the interest rate by increasing the level of production, thus making the loan more risky. Also, a firm might lower the production level when market conditions are improved. And finally, the production decision may be discontinuous.