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A Theory of Firm Decline

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  • Gian Luca Clementi

    ()
    (New York University, USA and The Rimini Centre of Economic Analisys, Italy)

  • Thomas Cooley

    ()
    (New York University and NBER, USA)

  • Sonia Di Giannatale

    ()
    (Centro de Investigaci´on y Docencia Econ´omicas, M´exico)

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 andquite 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, capital and firm value start declining and so does the value of outside equity. The reason is that incentive provision becomes costlier as inside equity grows. In turn, this leads to a decline in the constrained–efficient level of effort and therefore to a drop in the return to investment. In the long run, the entrepreneur gains control of all cash–flow rights and the capital stock converges to a constant value.

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Bibliographic Info

Paper provided by The Rimini Centre for Economic Analysis in its series Working Paper Series with number 33-08.

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Date of creation: Jan 2008
Date of revision: Jan 2008
Handle: RePEc:rim:rimwps:33-08

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

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  1. Bohacek Radim, 2005. "Capital Accumulation in Private Information Economies," The B.E. Journal of Macroeconomics, De Gruyter, vol. 5(1), pages 1-24, December.
  2. Aubhik Khan & B. Ravikumar, 1998. "Growth and Risk-Sharing with Private Information," Macroeconomics 9802003, EconWPA.
  3. Espino, Emilio, 2004. "On Ramsey's Conjecture: Efficient Allocations in the Neoclassical Growth Model with Private Information," Economics Series 154, Institute for Advanced Studies.
  4. 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.
  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. Mele, Antonio, 2010. "Repeated moral hazard and recursive Lagrangeans," MPRA Paper 21741, University Library of Munich, Germany.
  2. Loderer, Claudio & Waelchli, Urs, 2010. "Firm age and performance," MPRA Paper 26450, University Library of Munich, Germany.
  3. Tsyrennikov, Viktor, 2013. "Capital flows under moral hazard," Journal of Monetary Economics, Elsevier, vol. 60(1), pages 92-108.
  4. 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.
  5. Emilio Espino, 2012. "Investment and Insurance in an Economic Union," 2012 Meeting Papers 1176, Society for Economic Dynamics.
  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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