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Optimal Contracting with Moral Hazard and Cascading

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  • Khanna, Naveen

Abstract

In this article I identify optimal incentive contracts for managers of firms competing in the product market. Such firms often confront similar decisions and uncertainties. Managers can improve decision quality by generating private signals through costly effort. However, since signals are likely to be correlated, firms that decide later get additional information from the actions of earlier firms. This impacts effort choice. Decision quality is also affected if later managers disregard their own signals and blindly imitate preceding decisions. In a competitive environment, such cascading hurts profits. Contracts that solve both moral hazard and cascading problems typically put more weight on firm profits, making them expensive. Contacts with more weight on decision quality are less expensive but result in cascades. Shareholders choose contracts that maximize their net surplus. This results in testable implications about which industries may have more convergence in investment choices, greater pay-for-profit sensitivity, larger differences in observed contracts, more innovation, larger-size firms, and potential for overcompensation. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Suggested Citation

  • Khanna, Naveen, 1998. "Optimal Contracting with Moral Hazard and Cascading," Review of Financial Studies, Society for Financial Studies, vol. 11(3), pages 559-596.
  • Handle: RePEc:oup:rfinst:v:11:y:1998:i:3:p:559-96
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    Cited by:

    1. Akdo─ču, Evrim & MacKay, Peter, 2012. "Product markets and corporate investment: Theory and evidence," Journal of Banking & Finance, Elsevier, vol. 36(2), pages 439-453.
    2. Pegaret Pichler, 2004. "Optimal Contracts for Teams of Money Managers," Econometric Society 2004 North American Winter Meetings 495, Econometric Society.
    3. 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.
    4. Sushil Bikhchandani & David Hirshleifer & Ivo Welch, 1998. "Learning from the Behavior of Others: Conformity, Fads, and Informational Cascades," Journal of Economic Perspectives, American Economic Association, vol. 12(3), pages 151-170, Summer.
    5. Khanna, Naveen & Sonti, Ramana, 2004. "Value creating stock manipulation: feedback effect of stock prices on firm value," Journal of Financial Markets, Elsevier, vol. 7(3), pages 237-270, June.

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