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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.

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File URL: http://www.coll.mpg.de/pdf_dat/2007_08online.pdf
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Bibliographic Info

Paper provided by Max Planck Institute for Research on Collective Goods in its series Working Paper Series of the Max Planck Institute for Research on Collective Goods with number 2007_8.

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Length: 58 pages
Date of creation: Jun 2007
Date of revision:
Handle: RePEc:mpg:wpaper:2007_8

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Keywords: Financial Contracting; Debt Finance; Equity Finance; Moral Hazard; Risk Choices;

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References

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  1. Patrick Bolton & Mathias Dewatripont, 2005. "Contract Theory," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262025760.
  2. Caillaud, B & Guesnerie, Roger & Rey, P, 1992. "Noisy Observation in Adverse Selection Models," Review of Economic Studies, Wiley Blackwell, vol. 59(3), pages 595-615, July.
  3. Harris, Milton & Raviv, Artur, 1991. " The Theory of Capital Structure," Journal of Finance, American Finance Association, vol. 46(1), pages 297-355, March.
  4. Aghion, Philippe & Bolton, Patrick, 1989. "The financial structure of the firm and the problem of control," European Economic Review, Elsevier, vol. 33(2-3), pages 286-293, March.
  5. Holmstrom, Bengt & Milgrom, Paul, 1987. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, Econometric Society, vol. 55(2), pages 303-28, March.
  6. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  7. Dionne, G. & Viala, P., 1992. "Optimal Design of Financial Contracts and Moral Hazard," Cahiers de recherche 9219, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  8. Innes, Robert D., 1990. "Limited liability and incentive contracting with ex-ante action choices," Journal of Economic Theory, Elsevier, vol. 52(1), pages 45-67, October.
  9. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  10. Hart, Oliver, 1995. "Firms, Contracts, and Financial Structure," OUP Catalogue, Oxford University Press, number 9780198288817.
  11. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  12. Bester,Helmut Hellwig,Martin, 1987. "Moral hazard and equilibrium credit rationing: An overview of the issues," Discussion Paper Serie A 125, University of Bonn, Germany.
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Cited by:
  1. 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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