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A Theory of Firm Decline

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  • Gian Luca Clementi
  • Thomas F. Cooley
  • Sonia Di Giannatale

Abstract

We study the problem of an investor who 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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15192.

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Date of creation: Jul 2009
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Publication status: published as Gian Luca Clementi & Thomas Cooley & Soni Di Giannatale. "A Theory of Firm Decline," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics. Volume 13, Issue 4, October 2010, Pages 861-885
Handle: RePEc:nbr:nberwo:15192

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  1. Sandro Brusco & Eva Ropero, 2007. "Financing Constraints and Firm Dynamics with Durable Capital," Department of Economics Working Papers, Stony Brook University, Department of Economics 07-08, Stony Brook University, Department of Economics.
  2. Espino, Emilio, 2004. "On Ramsey's Conjecture: Efficient Allocations in the Neoclassical Growth Model with Private Information," Economics Series, Institute for Advanced Studies 154, Institute for Advanced Studies.
  3. Khan, A. & Ravikumar, B., 1997. "Growth and Risk-Sharing with Private Information," Working Papers, University of Iowa, Department of Economics 97-13, University of Iowa, Department of Economics.
  4. Fernandes, Ana & Phelan, Christopher, 2000. "A Recursive Formulation for Repeated Agency with History Dependence," Journal of Economic Theory, Elsevier, Elsevier, vol. 91(2), pages 223-247, April.
  5. Bohacek Radim, 2005. "Capital Accumulation in Private Information Economies," The B.E. Journal of Macroeconomics, De Gruyter, De Gruyter, vol. 5(1), pages 1-24, December.
  6. Zhiguo He & Neng Wang & Mike Fishman & Peter DeMarzo, 2008. "Dynamic agency and the q theory of investment," 2008 Meeting Papers 1070, Society for Economic Dynamics.
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Cited by:
  1. Tsyrennikov, Viktor, 2013. "Capital flows under moral hazard," Journal of Monetary Economics, Elsevier, Elsevier, vol. 60(1), pages 92-108.
  2. Hengjie Ai & Rui Li, 2012. "Moral hazard, investment, and firm dynamics," CQER Working Paper, Federal Reserve Bank of Atlanta 2012-01, Federal Reserve Bank of Atlanta.
  3. Loderer, Claudio & Waelchli, Urs, 2010. "Firm age and performance," MPRA Paper 26450, University Library of Munich, Germany.
  4. Antonio Mele, 2008. "Repeated Moral Hazard and Recursive Lagrangeans," 2008 Meeting Papers 482, Society for Economic Dynamics.
  5. Josepa Miquel-Florensa, 2013. "Dynamic contractual incentives in the face of a Samaritans’s dilemma," Theory and Decision, Springer, Springer, vol. 74(1), pages 151-166, January.
  6. Emilio Espino, 2012. "Investment and Insurance in an Economic Union," 2012 Meeting Papers, Society for Economic Dynamics 1176, Society for Economic Dynamics.

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