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A reconsideration of the Jensen-Meckling model of outside finance

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  • Hellwig, Martin F.

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 insufficient 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, the comparison depends on the elasticity of substitution. If firm returns are not too noisy as signals of behaviour, the optimal incentive scheme corresponds to some mix of debt and equity finance. If firm returns are too noisy, this interpretation is not available.

Suggested Citation

  • Hellwig, Martin F., 2009. "A reconsideration of the Jensen-Meckling model of outside finance," Journal of Financial Intermediation, Elsevier, vol. 18(4), pages 495-525, October.
  • Handle: RePEc:eee:jfinin:v:18:y:2009:i:4:p:495-525
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    References listed on IDEAS

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    1. Patrick Bolton & Mathias Dewatripont, 2005. "Contract Theory," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262025760, January.
    2. B. Caillaud & R. Guesnerie & P. Rey, 1992. "Noisy Observation in Adverse Selection Models," Review of Economic Studies, Oxford University Press, vol. 59(3), pages 595-615.
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    5. Holmstrom, Bengt & Milgrom, Paul, 1987. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, Econometric Society, vol. 55(2), pages 303-328, 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, Universite de Montreal, Departement de sciences economiques.
    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. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
    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.
    13. Douglas Gale & Martin Hellwig, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Oxford University Press, vol. 52(4), pages 647-663.
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    Cited by:

    1. Bijlsma, Michiel & Boone, Jan & Zwart, Gijsbert, 2012. "Competition for traders and risk," CEPR Discussion Papers 8816, C.E.P.R. Discussion Papers.
    2. Richard T. Thakor & Andrew W. Lo, 2017. "Optimal Financing for R&D-Intensive Firms," NBER Working Papers 23831, National Bureau of Economic Research, Inc.
    3. 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.
    4. repec:oup:revfin:v:21:y:2017:i:5:p:1805-1846. is not listed on IDEAS
    5. Fabiana Gómez & Jorge Ponce, 2015. "Regulation and Bankers' Incentives," Documentos de trabajo 2015005, Banco Central del Uruguay.
    6. repec:oup:rcorpf:v:5:y:2016:i:1:p:36-75. is not listed on IDEAS
    7. 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.
    8. 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.
    9. Alexei Tchistyi, 2012. "Risking Other People's Money: Gambling, Limited Liability, and Optimal Incentives," 2012 Meeting Papers 1091, Society for Economic Dynamics.
    10. repec:oup:rfinst:v:21:y:2017:i:5:p:1805-1846. is not listed on IDEAS

    More about this item

    Keywords

    Financial contracting Debt finance Equity finance Moral hazard Risk choices;

    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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