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A Reconsideration of the Jensen-Meckling Model of Outside Finance

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  • Martin Hellwig

    (Max Planck Institute for Research on Collective Goods, Bonn)

Abstract

The paper studies outside finance in a model of two-dimensional moral hazard, involving risk choices as well as effort choices. If the entrepreneur has insu¢ cient funds, a first-best outcome cannot be implemented. Second-best outcomes involve greater failure risk than first-best outcomes. For a Cobb-Douglas technology, second-best effort and investment levels are smaller than first-best; for other technologies, they depend on the elasticity of substitution. If firm returns not too noisy signals of be-haviour, suitable incentives can be provided by some mix of debt and equity issues. If firm returns involve too much noise, this is not possible.

Suggested Citation

  • Martin Hellwig, 2007. "A Reconsideration of the Jensen-Meckling Model of Outside Finance," Discussion Paper Series of the Max Planck Institute for Research on Collective Goods 2007_8, Max Planck Institute for Research on Collective Goods.
    • Handle: RePEc:mpg:wpaper:2007_8
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    References listed on IDEAS

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    2. Viral V. Acharya & Hamid Mehran & Anjan V. Thakor, 2016. "Caught between Scylla and Charybdis? Regulating Bank Leverage When There Is Rent Seeking and Risk Shifting," The Review of Corporate Finance Studies, Society for Financial Studies, vol. 5(1), pages 36-75.
    3. Michiel Bijlsma & Jan Boone & Gijsbert Zwart, 2018. "Competition for traders and risk," RAND Journal of Economics, RAND Corporation, vol. 49(4), pages 855-876, December.
    4. Ron Kaniel & Péter Kondor, 2013. "The Delegated Lucas Tree," Review of Financial Studies, Society for Financial Studies, vol. 26(4), pages 929-984.
    5. Alexei Tchistyi, 2012. "Risking Other People's Money: Gambling, Limited Liability, and Optimal Incentives," 2012 Meeting Papers 1091, Society for Economic Dynamics.
    6. repec:oup:rfinst:v:21:y:2017:i:5:p:1805-1846. is not listed on IDEAS
    7. Fabiana Gómez & Jorge Ponce, 2019. "Regulation and Bankers’ Incentives," Journal of Financial Services Research, Springer;Western Finance Association, vol. 56(3), pages 209-227, December.
    8. Mäkinen, Taneli & Sarno, Lucio & Zinna, Gabriele, 2020. "Risky bank guarantees," Journal of Financial Economics, Elsevier, vol. 136(2), pages 490-522.
    9. Kang, Chang-Mo & Kim, Donghyun, 2022. "Risk management transparency and compensation," Journal of Corporate Finance, Elsevier, vol. 75(C).
    10. Benjamin Hébert, 2018. "Moral Hazard and the Optimality of Debt," Review of Economic Studies, Oxford University Press, vol. 85(4), pages 2214-2252.
    11. Richard T. Thakor & Andrew W. Lo, 2017. "Optimal Financing for R&D-Intensive Firms," NBER Working Papers 23831, National Bureau of Economic Research, Inc.
    12. Mahmoud Sami Nabi, 2016. "Revisiting equity and debt: access to finance and economic inefficiency," International Review of Economics, Springer;Happiness Economics and Interpersonal Relations (HEIRS), vol. 63(4), pages 393-429, December.
    13. Mario Tirelli, 2021. "On the optimal investment finance of small businesses," Small Business Economics, Springer, vol. 56(4), pages 1639-1665, April.
    14. Francis de Véricourt & Denis Gromb, 2019. "Financing Capacity with Stealing and Shirking," Management Science, INFORMS, vol. 65(11), pages 5128-5141, November.
    15. Ingolf Dittmann & Ko-Chia Yu & Dan Zhang, 2017. "How Important Are Risk-Taking Incentives in Executive Compensation?," Review of Finance, European Finance Association, vol. 21(5), pages 1805-1846.
    16. Guembel, Alexander & White, Lucy, 2014. "Good cop, bad cop: Complementarities between debt and equity in disciplining management," Journal of Financial Intermediation, Elsevier, vol. 23(4), pages 541-569.
    17. Barron, Daniel & Georgiadis, George & Swinkels, Jeroen M., 2020. "Optimal contracts with a risk-taking agent," Theoretical Economics, Econometric Society, vol. 15(2), May.
    18. Sundaram, Rangarajan K. & Yermack, David, 2006. "Pay Me Later: Inside Debt and Its Role in Managerial Compensation," SIFR Research Report Series 43, Institute for Financial Research.

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    More about this item

    Keywords

    Financial Contracting; Debt Finance; Equity Finance; Moral Hazard; Risk Choices;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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