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A Model of Optimal Government Bailouts

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  • Bernardo, Antonio
  • Talley, Eric
  • Welch, Ivo

Abstract

We analyze incentive-efficient government bailouts within a canonical model of intra-firm moral hazard. Bailouts exacerbate the moral hazard of firms and managers in two ways. First, they make them less averse to failing. Second, the taxes to fund bailouts dampen their incentives. Nevertheless, if third-party externalities from keeping the firm alive are strong, bailouts can improve welfare. Our model suggests that governments should use bailouts sparingly, where social externalities are large and subsidies small; eliminate incumbent owners and managers to improve a priori incentives; and finance bailouts through redistributive taxes on productive firms instead of forcing recipients to repay in the future.

Suggested Citation

  • Bernardo, Antonio & Talley, Eric & Welch, Ivo, 2011. "A Model of Optimal Government Bailouts," Berkeley Olin Program in Law & Economics, Working Paper Series qt8wv4p90c, Berkeley Olin Program in Law & Economics.
    • Handle: RePEc:cdl:oplwec:qt8wv4p90c
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    References listed on IDEAS

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    Cited by:

    1. Zhang Li & Xiaojun Lin & Borja Peleato-Inarrea & Ilya Pollak, 2014. "Optimal Monitoring and Mitigation of Systemic Risk in Financial Networks," Papers 1410.2570, arXiv.org, revised Dec 2014.

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