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Managerial Incentives and Capital Management

In Holmstrom (1982) an example is given, which shows that a manager's concern for the value of his human capital will lead to a natural incongruity in risk-preferences between himself and the owners, even when no effort considerations are involved. In this paper we present a formal model of this channel of incongruity based on learning about managerial talent. We also explore the nature of an optimal incentive contract in the case where the manager may withhold but not misrepresent information about investment returns. The optimal contract is an option on the manager's human capital value with a possible bonus for investing. The optimal investment rule accepts fewer investments than under the cost of capital -- a commonly observed real world feature. Another phenomena the model helps explain is the extensive use of capital budgeting and rationing schemes in place of linear or non-linear price decentralization, which are shown to be less efficient modes of allocation.

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File URL: http://cowles.econ.yale.edu/P/cd/d07a/d0729.pdf
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Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 729.

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Length: 54 pages
Date of creation: Nov 1984
Date of revision:
Publication status: Published in Quarterly Journal of Economics (November 1986), 101(4): 835-860
Handle: RePEc:cwl:cwldpp:729
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Web page: http://cowles.econ.yale.edu/

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Order Information: Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA

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  1. Holmstrom, Bengt R & Weiss, Laurence, 1985. "Managerial Incentives, Investment, and Aggregate Implications: Scale Effects," Review of Economic Studies, Wiley Blackwell, vol. 52(3), pages 403-25, July.
  2. Milton Harris & Bengt Holmstrom, 1981. "A Theory of Wage Dynamics," Discussion Papers 488, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  3. Sanford J Grossman & Oliver D Hart, 2001. "An Analysis of the Principal-Agent Problem," Levine's Working Paper Archive 391749000000000339, David K. Levine.
  4. Ross, Stephen A, 1973. "The Economic Theory of Agency: The Principal's Problem," American Economic Review, American Economic Association, vol. 63(2), pages 134-39, May.
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