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A Theory of Firm Decline

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  • Gian Luca Clementi
  • Thomas F. Cooley
  • Sonia DiGiannatale

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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File URL: http://pages.stern.nyu.edu/~gclement/Papers/Decline.pdf
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Bibliographic Info

Paper provided by New York University, Leonard N. Stern School of Business, Department of Economics in its series Working Papers with number 09-05.

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Date of creation: 2009
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Handle: RePEc:ste:nystbu:09-05

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Postal: New York University, Leonard N. Stern School of Business, Department of Economics, 44 West 4th Street, New York, NY 10012-1126
Phone: (212) 998-0860
Fax: (212) 995-4218
Web page: http://w4.stern.nyu.edu/economics/
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References

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  1. Aubhik Khan & B. Ravikumar, 1998. "Growth and Risk-Sharing with Private Information," Macroeconomics 9802003, EconWPA.
  2. 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.
  3. 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.
  4. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  5. Bohacek Radim, 2005. "Capital Accumulation in Private Information Economies," The B.E. Journal of Macroeconomics, De Gruyter, vol. 5(1), pages 1-24, December.
  6. Espino, Emilio, 2004. "On Ramsey's Conjecture: Efficient Allocations in the Neoclassical Growth Model with Private Information," Economics Series 154, Institute for Advanced Studies.
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Cited by:
  1. Mele, Antonio, 2014. "Repeated moral hazard and recursive Lagrangeans," Journal of Economic Dynamics and Control, Elsevier, vol. 42(C), pages 69-85.
  2. Emilio Espino, 2012. "Investment and Insurance in an Economic Union," 2012 Meeting Papers 1176, Society for Economic Dynamics.
  3. Hengjie Ai & Rui Li, 2012. "Moral hazard, investment, and firm dynamics," CQER Working Paper 2012-01, Federal Reserve Bank of Atlanta.
  4. Loderer, Claudio & Waelchli, Urs, 2010. "Firm age and performance," MPRA Paper 26450, University Library of Munich, Germany.
  5. 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.
  6. Tsyrennikov, Viktor, 2013. "Capital flows under moral hazard," Journal of Monetary Economics, Elsevier, vol. 60(1), pages 92-108.

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